When oil prices soar, you may feel it at the pump, but that’s just one part of the story.
Despite moves toward renewable forms of energy, oil still plays a major role in the world
economy, so its price is one of many pillars in the financial markets.
Let’s take a closer look at why the price of oil matters and how it can impact your
portfolio.
First, what exactly are we referring to when we talk about the price of oil?
The price of oil is tracked per barrel and is based on two major benchmarks: Brent and
West Texas Intermediate, or WTI.
There are other benchmarks from around the world, like the Dubai, but the Brent and WTI
affect the United States the most.
These benchmarks give investors a picture of the price of oil worldwide.
So, how are these benchmark prices set?
Unsurprisingly, it has a lot to do with supply and demand.
For example, when the coronavirus pandemic hit in early 2020, oil prices plummeted as
economies shut down and demand for oil dried up almost overnight.
But as the world economy began to reopen in late 2020 and 2021, demand ramped back up
as travel and consumption resumed.
Coal and natural gas shortages at the same time increased the demand.
But supply was not able to keep pace, sending oil prices skyrocketing.
This was partially due to decreased production capacity resulting from a decade of falling
oil prices and investments before the pandemic hit.
But the 2021 situation also highlighted the role politics can play in oil prices.
One of the major players in oil production is the Organization of the Petroleum Exporting
Countries, or OPEC.
It’s an intergovernmental organization of countries that coordinate and unify petroleum
policies to keep prices favorable for them.
In late 2021, OPEC planned to only modestly increase output, keeping supply low even as
demand surged, leading prices to spike.
So how can the price of oil impact the economy?
It’s important to point out that with oil prices and the economy, there’s a bit of
chicken and the egg situation.
Economic activity affects supply and demand for oil, which affects oil prices, which can
in turn affect economic activity.
The relationship is circular, and the starting point isn’t always clear.
Crude oil, that is, oil that’s drilled from the ground to make things like kerosene, gasoline,
and asphalt, is especially important because it’s used to extract lots of other raw materials
to produce and transport goods.
When oil gets more expensive, so does basically everything else.
This can lead to inflation, which can hurt economic growth.
For example, in the â€˜70s, economic growth stalled, due in part to political crises that
caused oil prices and inflation to soar.
That’s why people tend to think low oil prices are good for the U.S. economy; however,
high oil prices aren’t always devastating.
Consider this: One of the best recent years for the U.S. stock market was 2013, when the
economy really started to recover from the Great Recession of 2008.
Through much of 2013, the price of crude was above $100 per barrel, and gas cost more than
$3 per gallon across much of the country.
High crude prices didn’t make the wheels fall off then, so high crude prices alone
isn’t necessarily a speed bump to a growing economy.
So how does this translate to the stock market?
There’s evidence that oil prices and the stock market can move in the same direction.
Sometimes they’re both reacting to a common factor.
For example, during the coronavirus pandemic, economic activity dropped and so did demand
for oil.
However, if oil prices rise enough to cause inflation that hurts economic growth, it could
cause issues for the overall stock market as well.
In periods of extremely high oil prices, so high that it affects the fundamentals of individual
companies, there’s the possibility that valuations may begin to look less attractive
and stock performance can potentially decouple from oil price performance.
There are a few areas of the stock market where oil prices can have a particularly big
impact.
The most obvious is the Energy sector.
The S&P Energy sector’s two largest components are Exxon and Chevron, which are fossil fuel
companies, meaning where they go, often times, the sector goes as well.
It’s not a surprise then that the sector tends to perform better when oil prices are
high, though renewable energy companies are seeing continued growth, opportunity, and
better cost dynamics.
Companies that deal directly with moving goods or people like airlines and parcel delivery
services are also directly affected by oil prices.
Higher fuel prices can eat into their profits or eventually lead them to pass those increased
prices on to their customers.
Most of the big Consumer Discretionary sector companies like Target or Amazon benefit by
sourcing products in places like China where labor is cheaper and then shipping those finished
goods to the United States, Canada, and Europe.
The cost of shipping isn’t typically a huge determinant of companies’ operating margins,
but expenses can certainly leave a dent when crude stays high, eventually figuring into
bottom-line growth.
Or again the companies could pass along higher prices to customers, fueling inflation.
Due to climate change, oil faces an uncertain future.
Many car companies are going electric, and there’s increasing interest in Environmental,
Social, and Governance, or ESG, shifting investment of time and capital to renewable energy.
A possible outcome is the global economy slowly transitioning away from oil.
The question is how oil producing companies might shift their approach to meet a changing
market.
In the meantime, the price of oil can have a big impact on the economy and markets, and
it's an important indicator to consider when making decisions about your portfolio.
Just remember, historically speaking, high or low oil prices don’t absolutely spell
doom or success for the markets.