The Price of Crude Oil and Equity Prices

droplet of crude oil
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Markets tend to reflect the world around them. One of the basic principles of physics, Newton's third law, is that for every action there is an equal and opposite reaction. In markets, the same tends to be true -- action in one market affects others. However, sometimes there is a lagged effect.

Why Crude Oil?

Crude oil is one of the most important commodities when it comes to both global finance and geopolitics.

That is because production and the majority of reserves of the energy commodity occur in one of the most turbulent regions of the world, the Middle East. Consumption is widespread, people and businesses all over the world depend on oil and oil products for the energy that makes the world work and move.

As perhaps the most political and ubiquitous commodity, the price action in crude oil affects other markets. One asset class that is generally responsive to changes in the price of oil is equities. Many companies are consumers of oil and a lower price allows these firms to reduce prices thus making them more competitive. Lower energy costs decrease the cost of goods sold thus increasing profit margins. For individual consumers, lower oil prices are a good thing -- it means more discretionary income. However, for those involved in oil production, exploration or services for the petroleum industry a lower price does quite the opposite.

Moreover, the impact of lower oil prices on consumers is less important than on producers. For consumers, a lower oil price only affects a part of their overall business. For producers, lower oil prices affect the totality of their business.

In the United States equity markets, there are many listed companies involved in all aspects of the petroleum market.

These highly capitalized companies are important components of indices that investors and traders watch on a daily basis. Therefore, lower oil tends to have a negative influence on equity indices and stock prices in general. However, in 2015 and early 2016 a divergence emerged between the price of crude oil and oil equities. The price of crude oil traded at over $107 per barrel in June 2014. At that time the price of the Energy Select SPDR (XLE), an ETF of oil stocks in the U.S., was at over $101 per share. During January 2016, the price of NYMEX active month crude oil plunged to the lowest level since May 2003 when it traded to lows of $26.19 per barrel on January 20. The XLE moved lower with crude oil, on the same date the ETF traded at lows of $49.93 per share. However, in May 2003 that same ETF was trading at levels that were under $22 per share. Therefore, the performance of the XLE lagged the performance of crude oil.

One of the reasons for the lag could have been that when oil made a new multi-year low at around $42 in March 2015, it quickly recovered to over $60 per barrel. In late August of 2015, when crude oil made yet another new low at $37.75 it quickly rallied to over $50.

The equity market in late January could have been waiting for yet another recovery in the price of the energy commodity in early 2016. This did happen as the price of nearby crude oil moved to highs of $34.82 on January 28 -- a price increase of over 30% in just eight days. At the same time, the XLE moved around $7 or 14% higher over the period.

The bottom line has been that the price of oil equities has not properly reflected the action in crude oil as the XLE remains well levels seen in 2008 while crude oil itself moved much lower. This tells us that either the price of oil fell too far or the price of oil equities had yet to catch up with the price of the commodity.

Divergences like this often create opportunity. Professional traders constantly analyze markets looking for divergence. When asset prices diverge, the opportunity for a mean reversion trade arises.

This means that one market that lags another will eventually catch up yielding profits for those who buy one and sell the other. In this case, a sale of the XLE ETF and simultaneous purchase of crude oil futures would set up a trade or investment that would yield positive results if the lagging ETF catches up with the price of oil. Another ramification of this divergence could be that equity prices, in general, could fall as the price of crude oil has moved so aggressively lower over past months. The fact that crude oil related equities are prevalent in equity indices could make this a self-fulfilling prophecy.