Markets usually have an impact on the world around them. One of the fundamental principles of physics, Newton’s third law, is that for every action there is an equal and opposite reaction. In markets, it’s similar: an action in one market affects other markets. However, sometimes there is a lag in the effect.
Why Crude Oil?
Crude oil is considered one of the most important commodities when it comes to global finance and geopolitics. The production and the majority of reserves for this energy commodity occur in one of the most volatile regions in the world, the Middle East. People and companies around the world rely on oil and oil products for energy that keeps the world running and moving.
How Does Crude Oil Affect Markets?
As one of the most politicized and widely traded commodities, the movement of crude oil prices impacts other markets. The asset class that generally responds to changes in oil prices is stocks. There are many companies that consume oil, and a lower price allows these companies to reduce costs, making them more competitive. Lower energy costs reduce the prices of goods sold, thereby increasing profit margins.
For individual consumers, falling oil prices are generally a good thing: they mean increased disposable income. However, for those engaged in oil production, exploration, or providing services to the oil industry, lower prices mean the exact opposite. Moreover, the impact of falling oil prices on consumers is less significant than on producers. For consumers, the lower oil price only affects a portion of their overall business. For producers, declining oil prices impact every aspect of their operations.
In the U.S. stock markets, there are many publicly traded companies involved in all aspects of the oil market. These large-cap companies are significant components of the indices that investors and traders track daily. Therefore, the decline in oil prices tends to have a negative effect on stock indices and stock prices in general.
Notable Events in Crude Oil Pricing
However, in 2015 and early 2016, a divergence appeared between crude oil prices and oil stocks. The price of crude oil traded above $107 per barrel in June 2014. At that time, the price of the Energy Select Sector SPDR Fund (XLE), an exchange-traded fund for U.S. oil stocks, was around $100 per share. During January 2016, the active NYMEX crude oil price dropped to its lowest level since May 2003, averaging $31.78 per barrel for the month.
When the price of oil fell to a new multi-year low of around $42 in March 2015, it quickly rebounded to over $60 per barrel. The stock market at the end of January could have been anticipating another rebound in the price of the energy commodity early in 2016. This rise occurred when the nearby crude oil price peaked at $26.68 per barrel in January 2016.
Conclusion
The key point is that oil stock prices did not accurately reflect the movement in crude oil prices as the XLE fund remains at lower levels than those seen in 2008, while crude oil prices have dropped significantly. This scenario tells us that either oil prices have declined dramatically or oil stock prices have not kept pace with commodity prices.
Such divergences often create opportunities. Professional traders continuously analyze markets for discrepancies. When asset prices deviate, an opportunity for corrective trading arises. This opportunity for divergence means that a market lagging behind another will ultimately catch up, leading to profits for those who buy in one market and sell in another.
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In this case, selling the XLE fund and buying crude oil futures contracts in one trade setup or investment can lead to positive results if the lagging investment fund corresponds to the price of oil. This divergence can also have another impact on stock prices in general, as stock prices may decline significantly due to the extreme drop in crude oil prices over the past months. The fact that oil-related stocks dominate in stock indices can make this a self-fulfilling prophecy.
Source: https://www.thebalancemoney.com/the-price-of-crude-oil-and-equity-prices-808866
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