Oil Prices and How They Affect the Stock Market

¶ … oil prices and the stock market. The relationship between oil prices and increases in costs to transportation, heating and production are reviewed, and the role of spiking oil prices on market uncertainty is discussed. Overall, higher oil prices are historically linked to declining stock market prices, and it seems reasonable to suggest that future stock market decreases will come from current increases in oil prices.

Stock market performance is strongly linked to oil prices. Recently, oil has hit new price records, and the stock market has declined in response. This trend follows the historical relationship between oil and stocks, which has seen sharply rising oil prices as a strong predictor of stock market declines. Such stock market declines can be linked with increased costs due to high oil prices, as well as general market uncertainty.

Oil Prices and the Stock Market

Recently, oil prices have hit historic highs, and stock markets have moved downward in response. As of September 27th, 2004, oil futures hovered at a new high of $49.64 a barrel on the New York Mercantile Exchange. At the same time, stock averages declined in response. The Dow closed at 9,988.54, and the NASDAQ closed at 1,859.88, both showing a decline from previous levels (E-Commerce Times).

Historically high oil prices have been linked to drops in the stock market. Leeb and Leeb (2004) write, "For the past thirty years, the price of oil has been the single most important determinant of the economy and the stock market" (p. 4). Specifically, declining oil prices, as well as slowly increasing prices have been associated with strong stock market performances. In contrast, sharp rises in the price of oil have had a profoundly negative impact on the American economy and stock market (Leeb and Leeb, 2004).

The time between the peak of oil prices to declines on the New York Stock exchange has historically been between two months and 17 months, with an average of 12 months (McMahon).

The relationship between rising oil prices and falling stocks has been seen repeatedly throughout the past thirty years. Form 1973 to 1982 when oil prices rose from $5 to $30 USD a barrel also saw double digit inflation, and two recessions. The same pattern was seen in 1987, when rising oil prices saw stocks tumble by more than 30% on the Dow Jones Industrial Average. Stocks fell again when Saddam Hussein invaded Kuwait, and oil prices rose close to 50% over several weeks. From 1991 to 2000, stocks remained strong as oil prices held steady (Leeb and Leeb, 2004).

There is some disagreement among financial experts about the direct effect between oil prices and the U.S. economy. Nonetheless, any significant market rally is unlikely under conditions of record oil prices (E-Commerce Times).

Higher oil prices increase costs in a number of areas, including production, heating, and transportation (McMahon). As such, it is logical to assume that the economy would perform more poorly under these conditions. Simply put, profits will decrease if expenses increase significantly, barring other factors. As profits decrease, stock markets will decrease as well as investor confidence declines.

Higher oil prices also result in a decline in spending on consumer goods. Wal-Mart has noted that its customers will spend about $7 each week more on fuel as a result of recent increases. This may lead directly to reduced spending on consumer goods, prompting Wal-Mart to remark that sales may decrease as a result (Evans).

Importantly, spiking oil prices introduce an element of uncertainly into the stock market (McMahon). As noted earlier, there is a well-known historical connection between rising oil prices and declining stock prices. This connection alone can worry investors in times of increasing oil prices, spurring a loss of investor confidence that can lead to market.

The link between oil prices and stock market performance is likely to remain strong as long as our economy retains its dependence on oil. Currently, the world is moving toward a shortage of oil that is economically viable to extract, making existing reserves in countries like Iraq and Saudi Arabia especially important. Today's economy depends on ensuring these reserves are available, while potentially working toward alternatives to oil as a long-term solution (Leeb and Leeb, 2004).

One important factor in controlling oil prices is the Strategic Petroleum Reserve. Oil can be released from the reserve in order to force oil prices to decline, thus potentially staving off any associated decreases in the stock market. The reserve is currently at about 660 million barrels (Evans).