Stock markets are known to be highly sensitive to various factors such as policy announcements, interest rates, exchange rates, economic stability, etc. Of these, an important factor is world oil prices. Stock markets are extremely volatile when it comes to the reaction to crude oil prices and fuel prices in different markets around the world. Read on to find out how they affect the stock market and how they matter to your portfolio.
a brief history
Between January 1973 and December 1974, almost every major stock market in the world, especially the UK, went into a bear market. this was considered to be the worst stock market downturn since the great depression. While there were other factors as well, the oil crisis that began in October 1973 caused oil prices to rise and was one of the main contributing reasons for the stock market crash. this is the most notable example of how oil prices affected stock markets.
More recently, crude oil derivatives contracts went negative in April 2020, due to oversupply (no buyers for the futures contract) due to the virus outbreak. Oil demand fell sharply as the entire world went into a lockdown. Despite the drop in demand, producers did not stop oil production in time, hoping that demand and oil prices would rise again.
However, that did not happen. and oil prices plummeted negative (wti crude oil).
despite this historic event in oil prices, the nasdaq index was hardly affected and only decreased 16 points in that week. decreased further in April, but recovered in mid-May.
effect on stock markets
Although there are some cases where sharp fluctuations in oil prices were accompanied by changes in the stock market, some recent studies suggest that oil prices have little effect on the stock market as a whole. in this case, correlation does not equal causation.
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Generally, market indices like nasdaq, nifty 50, bse sensex are not affected when oil prices fluctuate. This is because oil companies and other companies that are heavily affected by oil prices make up a very small portion of these indices.
effect on portfolio
While stock markets may not be affected as a whole, individual companies most definitely are. there are a few reasons:
- increasing input costs: Oil is an important input for several industries. When crude oil prices naturally rise, input costs and overall production costs also rise. This causes profit margins to drop, which in turn lowers that company’s stock price. on the contrary, a fall in oil prices produces the opposite effect. airlines, refineries, logistics, paints and other similar companies are the most affected in this type of situation.
- current account deficit: for every $10 increase in the price of oil, the current account deficit increases by 0.55%. This is because oil accounts for a large part of India’s total imports. every time the current account deficit increases, foreign exchange begins to flow out of the country. this leads to depreciation of the rupee. this means that imports are now more expensive as the government will have to pay more to obtain the same amount as before. as imports become more expensive, input costs rise and stock prices fall again. conversely, if oil prices fall, the opposite will happen. imports will be cheaper and stock prices will appreciate.
- increasing transportation costs: rising crude oil prices mean that transportation costs will rise, which in turn will increase the costs that the company has to bear. Again, this implies reduced profit margins and a decline in share prices. conversely, a drop in oil prices will cause stock prices to rise.
- increase in inflation: For every US$10 increase in the price of oil oil, the consumer price index (ipc) increased by 0.3%. when inflation rises, investor confidence in companies declines and negatively affects share prices. conversely, a fall in the price of oil increases investor confidence and positively affects stock prices.
food to go
While the stock market as a whole may not fluctuate wildly due to changes in oil prices, some companies that rely heavily on oil do. so take note of the crude oil price movement before investing in such companies.