Oil seems to be quite volatile in the market lately. Many people have even asked if falling oil prices mean the stock market is declining. And financial news isn’t helping.
Yes, oil is rather volatile right now. But that’s nothing new. And yes, the markets have been pretty out of sorts so far in 2016. But the unpredictability of the markets is just about the only thing you can predict about them.
Is the volatility of oil a result of the volatility of the markets? Or vice versa? Or neither?
Crude Oil Volatility: A Quick Glimpse at Correlation
Before we get too deep, here’s a quick correlation primer: Correlation is one method for measuring how two variables move in relation to each other. Coefficients ranging from 1 to -1 are used to measure correlation—1 means two series move together, -1 means they move opposite each other, and 0 indicates there is no relationship between the series. In other words, a 0 means the performance of one series tells you nothing about the other.
The monthly correlation of the crude oil spot return with US stocks (represented by the CRSP 1-10 Index) from 1986 to 2015 was 0.02. For the MSCI World ex USA Index (which is pretty much all of the stocks outside the US), the monthly correlation over the same time period was 0.05. Both of these are pretty close to 0, which tells us they are incredibly weak correlations.
To put this in perspective, the correlation between US Stocks (CRSP 1-10 Index) and the One Month US Treasury Bill over the same period also 0.02. In other words, oil is just as (un)correlated with the US stock market as short-term US Treasury bonds.
Over the past ten years, we have seen an upswing in the volatility of oil, some of which seems to match the swings of the stock market. As a result, the correlations between crude oil spot return and US stocks have increased.
So when you look at just the last ten years, the crude oil spot return has a correlation of 0.33 with the US Stock Market (CRSP 1-10 Index). If we look internationally, oil’s correlation with the international stock market (MSCI World ex US Index) has risen to 0.37.
So people are understandably wondering if moves in oil prices can tell them something about what the stock market will do. For that to happen, these higher correlations need to last—they can’t just be a fluke of the data.
So Will These Higher Correlations Persist?
The answer is, “It’s hard to tell.” One thing is certain: These correlations are contemporaneous. They are not evidence of predictability.
Look at the relation between previous oil price changes and market returns. The average returns between 1986 and 2015 show no evidence that falling oil prices predict declining stocks markets. So even though oil and stock prices are both declining, they aren’t contingent on each other.
Then why are oil prices falling? It’s hard to say, but we can rule out one reason.
The One Factor That Isn’t Responsible for Falling Oil Prices
Oil is not falling because of lessening demand. In fact, U.S. crude oil stock (inventory) has risen in recent months. Exhibit 2 shows how the stock of oil rose from less than 360 million barrels in late September 2014 to more than 490 million barrels on Jan. 22, 2016. And Exhibit 3 shows that refineries have been just as busy as always, though the ratio between domestic and foreign crude oil has changed. We’re still using oil as fast as ever, and we aren’t even really cutting the growth rate of our oil usage.
It’s possible that US statistics can’t capture a reduction in the global demand for crude oil. You can consider worldwide liquid fuels consumption a proxy for global oil demand. Using Exhibit 4 as a proxy, there’s still no evidence of slackening demand in recent months.
How Worried Should You Be?
Not very. The financial media cares about selling ads. Headlines that refer to “the oil crash” aren’t interested in your retirement.
It’s true that low oil prices could distress some firms in the energy industry since that sector includes refineries and natural gas producers. Exhibit 5 shows the weight of the energy sector in market indices.
On the other hand, a lot of businesses benefit from cheaper oil. Cheaper oil means cheaper gas, and cheaper gas means cheaper transportation costs. Because most of the goods that you buy are shipped from somewhere, prices could drop (ok, they probably just won’t go up as quickly).
How all of these competing factors will play out is anyone’s guess. There is simply no way to know how the market will move based on what oil does (to say nothing of trying to guess which way oil will go in the future).
So what should you do? Work your plan, stay disciplined with your investments, and focus on your long-term goals.
To find out more about investing in retirement, read our eBook 8 Tips to Becoming a Retirement Income Investor.
