There is a lot of new lately about lower oil prices hurting the stock market. This comes as a shock to casual investors who are used to HIGHER oil prices hurting the stock market. If lower oil prices are good for consumers, and the consumer drives the American economy, then why would lower oil prices hurt stocks?
Short-Term Stock Price Movements
One way to calculate a company’s value is it’s market capitalization which is the number of shares outstanding the company has times the company’s share price. As I write this, for example, IBM has a market capitalization of $154.76 billion dollars. However, it’s stock is down approximately $3 per share from yesterday. That means that, theoretically, the company was worth $157.85 billion dollars yesterday.
No matter what the price of oil is, there is no way that anything changed enough to make IBM worth $3 billion dollars less than yesterday. Short-term price fluctuations are the result of supply and demand. And, since a large majority of daily trades are actually between computers, in a very real way, you could say that short-term price movements in any stock are nothing more than the variables in differing computer programs.
What Cheap Oil Means for Stocks
That being said, the concept behind both computer trading programs, and actual investors buying and selling stock is that various events or company actions can, and do, ultimately impact the value, or worth, of a company and it’s shares.
When it comes to oil, different stocks react differently to changes in prices. For example, it should come as no shock that oil companies do better when oil prices are higher. When you are pulling a commodity out of the ground the approximate cost of doing so remains constant. So, the more you can sell it for, the higher your profit.
On the other hand, companies that use oil such as airlines and transportation companies do better when oil is cheaper. Filling a truck with gasoline and driving it across the country is cheaper when oil is cheaper. Assuming prices remain the same, then profits would increase with cheaper fuel expenses.
Furthermore, consumers are often cited as the real power behind the American economy, and cheaper gas means lower expenses for consumers. From this standpoint, cheaper oil is good for the economy and stocks in general.
So, why does cheap oil mess up stocks so much?
I once heard a professional financial analyst say that everything is worth something. The trick, is knowing what that something is.
To find out what something is worth, you take a look at all the data you have about that something and then project that against all the data you have about how that something will fit in the world. That gives you a value.
The more data you have and the more patterns you have to compare it against the better your projections can be. Conversely, the less of these things you have, the greater the margin for error. Which brings us to falling oil prices.
For the last several years, the world has gotten very used to oil in the neighborhood of $100 a barrel, give or take $10 or $20. We know what happens when oil is priced like this. However, with oil down near $50 per barrel, that is a whole new variable that no one is sure exactly how to deal with. When you don’t know, you need more room for error.
In addition, the economy had adjusted and settled into higher oil prices. There are enough companies, jobs, and transportation to handle $90 per barrel oil prices. With oil at $50 per barrel, the math changes. Perhaps there are too many companies, too many workers, too many suppliers, etc… As the economy adjusts that means changes. And, those changes are what many investors are trying to get out in front of.
Right now, that means bailing on oil companies, and pretty much anything that has anything to do with oil. If you want to take that one step further, than means getting out of anything that will be negatively affected by those companies or issues. Banks that have a large amount of loans out to oil industry companies, might be riskier now. What about big equipment makers? Oil shipping? Refineries?
Politicians in North Dakota have been tripping over themselves to take credit for the being the state with the fastest growing economy. But, if oil prices stay low and the oil industry has issues, which state do you think would have the fastest declining economy? (Think they’ll still try and take credit for that?)
Big Oil is Big
The other issue is simply size. It isn’t politicians just blowing smoke when they say “big oil.” The Fortune 500 ranks the top U.S. companies by sales. Guess how many are oil companies? Other than Wal-Mart, the two biggest companies in America are oil companies. Five of the top 25, or 20 percent of the biggest U.S. companies are directly involved in oil.
#2 Exxon Mobil
#6 Phillips 66
#10 Valero Energy
#25 Marathon Petroleum
Oil In Stock Indexes
Never forget that when the new gives it’s fifty-five second money segment is relies heavily on indexes when talking about the stock market.
The Dow Jones Industrial Average and the S&P 500 Index are the most widely reported. The Dow includes both Chevron and ExxonMobil, and since the Dow is a price-weighted index, and those companies are two and three in size, every movement of them causes out-sized moves in the Dow as well.
Long-Term Stock Market Impact
The markets frequently go through upheavels like this. That does not mean that lower oil prices are bad for stocks, or the economy in the long-term. Assuming prices remain low, the economy, and the companies in it, will adjust. There will be winners and losers. Oil companies, and those companies heavily dependent on them will suffer. Companies that use oil and gas will do better. In the end, however, cheaper oil is probably better for the U.S overall.
Once everyone gets there money where they think it should be based on cheaper oil, things will settle down. Until then, remember that there hasn’t been a correction (10% decline) in this market in a very long time. Stocks don’t go straight up, and when they do, that just sets up trouble down the road. Pretty much everyone is waiting for the shoe to drop, and cheaper oil might just be the excuse the market needs to take a healthy dip.