The price of oil and the movements of the stock market used to be quite unconnected, and indeed there were times that there was an inverse relation between the two.
But, since around the turn of the 21st century, and especially for the past two years, it seems like the two are joined at the hip; when oil dives, stocks go along for the ride.
Of course, there's no shortage of suggestions why.
In fact, every pundit appears to have a ready reason (or reasons) why the two are now in lockstep. And in each case, the rationale points toward some fundamental factor underlying both.
But unfortunately, none of these theories really explains what is actually happening.
No one has hit upon the cause of this phenomenon, which may explain why so many people are losing money. There are still lots of opportunities to make money here.
But first it's critical to explode the myths and understand the truth…
Oil Market Myth No. 1: "Falling Oil Prices Mean a Global Slowdown!"
This first "hypothesis" is the one heard most often these days: It's the economy, pure and simple.
This approach suggests that falling oil prices are actually signaling a global economic retrenchment. According to this argument, economic declines worldwide are translating into anticipated cuts in oil demand.
Some are even moving further, claiming that the oil plunge is presaging an international depression.
The problem with this logic is itself straightforward. First, despite concerns over China and other economies, aggregate energy demand is actually increasing. Pundits continue to spread a basic misunderstanding about the real impact of recent market trends.
Global economic strength is hardly dependent upon China having to sport a 7% annual growth rate at all times.
So here's the truth: Global aggregate markets are continuing to expand, while overall energy demand worldwide increased almost 3% last year, with 1.8% of that increase accounted for by oil alone.
In other words, there is no statistical basis for believing that declining oil prices are a harbinger of a collapse to come.
Indeed, the traditional result has been quite the opposite. Lower energy costs have generally translated into better, that is to say, cheaper, economic performance for broader markets.
And that brings us to another favorite pundit theory…
Oil Market Myth No. 2: "The Energy Debt Crisis Has Infected the Markets!"
This proffered "explanation" rests on the rising energy debt problem. The debt in question here is the high end of the high-yield curve (i.e., junk bonds), the interest on which is now spiking at well over 17.5%.
I've addressed this rising debt crisis as a major problem for U.S. oil companies in Money Morning and over at my Oil & Energy Investor service.
In short, as the price of oil has fallen, oil and gas production companies will increasingly struggle to pay back their loans. And with increasing yields, covering old loans with new debt is more and more costly.
The argument here is that this energy credit crunch is resulting in a downward pressure for the markets as a whole.
Yet for the impact energy debt has on some select exchange-traded funds (ETFs) and exchange-traded notes (ETNs), it remains a minority portion of the debt curve as a whole. For the argument here to hold, the worsening outlook for energy debt must be constricting the ability of banks to extend credit to other businesses.
But there is simply no indication that this is happening.
Yes, the increasing weight of debt is a real, rising crisis for heavily leveraged (usually smaller) energy companies, and yes, debt is contributing to a rise in bankruptcies and mergers/acquisitions in the energy sector.
And that's all the energy debt crisis is doing. There is no wider impact. Energy credit issues are not the reason broader markets are falling.
Some pundits say (and perhaps even believe) instead that it's the wider effects of the price of oil that are the culprit…
Oil Market Myth No. 3: "Plunging Energy Investment Is Weighing Down the Whole Economy!"
According to some, the markets falling alongside oil is a matter of general investment pressure.
The reasoning here is that oil capital expenditures comprise a primary source of investment into the economy as a whole.
As the price of oil has fallen, oil companies have been slashing their capital expenditure budgets, thus depriving the wider economy of investment.
Depending on which figures you accept, oil companies can account for as much as a third of capital expenditure (CapEx) among S&P 500 companies, while the oil industry workforce accounts for just a fraction of the national total.
Now, it has to be said that there is some truth to this argument: Companies have cut forward and new project investments, and that has translated into loss of jobs.
But that's exactly where the argument goes awry.
You see, oil companies continue to invest in existing fields and operations, along with select new projects – especially vertical, shallow drilling.
But then this is hardly an all-or-nothing situation. In fact, despite cuts to more expensive future projects, overall oil production is increasing as better technology and efficiency become the norm.
Meanwhile, the job losses remain limited to specific, isolated regions and job classifications.
Most importantly, neither oil-related job losses nor investment cuts have crossed over to the economy as a whole – where both the investment and employment pictures have been improving.
Faced with these facts, pundits often retreat to the corner – the one final "reason" why oil and stocks are linked…
Oil Market Myth No. 4: "Investors Are Selling Stocks to Cover Their Energy Losses!"
Having run out of other options, pundits will often appeal to some vague, ill-defined overall selling mentality.
In short, the dive in oil prices is forcing investors all over the world to sell other holdings to meet margins or other considerations.
Yet to the extent that this is happening at all, it is an indication of some rather narrow-sighted ideas of risk diversification. It is simply untrue that those investing heavily in crude are sacrificing other segments of the market.
Once again, there is no basis for such a crossover.
The Unvarnished Truth: Manufactured Panics Are Driving Down Both Oil and Stocks
There are a number of reasons why the stock market is moving down. Oil is only one of them, and hardly the main one.
As for what's keeping oil down, that is quite different…
The primary reason for the current dip in oil prices remains the global surplus in crude supply. This is partly due to simple supply and demand dynamics.
But the depth of this decline is a result of actions by certain funds and traders.
There is now a heavy short move on crude, augmented by the usage of exotic derivative papers in the futures contract market, along with large institutionalized "flash" and computerized trading.
It is here that I have to warn you about how certain pundits advance their own profits at the markets' expense…
And at yours.
So, here's how they're doing it.
Suppose "Chicken Little" from "The Sky Is Falling Hedge Fund" comes on screen and talks about oil moving down to $18 a barrel (or even lower). While doing so, he shows some moderated "panic."
Of course, the hedge fund is already running short positions on crude that will profit if anybody watching the interview buys the "panic."
As I have discussed before here Money Morning and in Oil & Energy Investor, I've set up an algorithm to track these artificial oil price machinations. That algorithm is now saying that the premium for these moves now averages $12 a barrel.
In other words, oil quoted at $30 has an actual market value of about $42.
To make this "panic" really stick, of course, "Chicken Little" has to talk about more than just oil. The more fear he can drum up about China's slowing growth, the U.S. economy, and so on, the better for him.
So much the worse for the stock market, which (just like the price of oil) ends up going down as investors retreat.
There are two main takeaways from this…
- Do not, under any circumstances, buy the "panics" pundits try to sell you on TV.
- We do not need a major upswing in prices to disconnect oil from the larger market. A stable price in the low $40s is enough to "shatter the illusion." That's when selling panics no longer work, and oil and stocks begin marching to their own drummers.
At that point, we are also likely to witness the more traditional result of low oil prices – other sectors of the market – and the energy sector itself – benefitting from a low price for crude oil.
And Chicken Little will have to go and play in some other barnyard.
Oil's "price problem" has given us the perfect setup for an under-the-radar trade set to hand you five times your money in the next 60 days. Now, these perfect conditions won't last, and all it takes is three minutes and one extra mouse click to get in. See the details here… and be ready to make your first move before the markets close.
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.