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Correlation in oil and equity price movements declines

Hydrocarbon Engineering,

The rolling 60 day correlation between daily percentage changes in the price of Brent crude oil and the Standard & Poor’s 500 equity index fell from +0.45 to +0.12 since 16th August. As a very broad generalisation, the correlation between oil and equity price movements tends to rise when current and expected demand developments are the primary concern of oil markets and to fall when supply issues are in the limelight.

Since mid August, the price of oil has moved higher in the wake of growing crude oil supply disruptions and rising concern about the conflict in Syria. Global unplanned crude oil and liquid fuels disruptions averaged 2.7 million bpd in August, the highest level since at least January 2011.

Energy Information Agency (EIA) estimates that Libya’s crude oil production disruption will average 1.4 million bpd in September, up from the estimated 980 000 bpd average during August. While Syria itself is not a major oil producer, its proximity to major oil producers in the Middle East may raise concern about the possibility of tighter oil supplies if the conflict spreads. In the last week of August, Brent increased to reach its highest level since February of this year, while the Standard & Poor (S&P) declined recently.

Previous supply disruptions also lowered the correlation between oil and equity prices. In spring 2011, the correlation between price movements in oil and equities plunged when the disruption of Libyan oil supply during the Arab Spring conflict led to a substantial rise in global crude prices. Significantly, higher crude oil and petroleum product prices can have an adverse impact on projected economic activities, reducing companies’ future expected earnings and thereby putting downward pressure on equity prices. Earlier, with the start of the Iraq War in the second quarter of 2003, the correlation between the movements of Brent and S&P 500 also declined sharply as crude oil prices rose with the disruption of supplies from Iraq.

The correlation between daily percentage price movements in oil and equity can also be viewed from a longer term perspective. From January 2001 to September 2008, the correlation averaged -0.04, demonstrating no relationship most of the time but with some periods of negative correlation. Since October 2008, the rolling 60 day correlation of the daily percentage change in the prices of Brent crude oil and the S&P 500 equity index has been positive over 95% of the time, averaging +0.48.

A possible cause of the longer term trend towards more positively correlated movements in oil and equity prices is the role of emerging market economies as both the driver of changes in global oil demand trends and a growing source of revenue for major publicly traded companies. In 2012, emerging market economies comprised 28% of the total world economy, as compared to 21% in 2003. As emerging market economies have grown, so has their demand for crude oil and petroleum products. While crude oil and liquids consumption by the mostly high income developed economies of Organization for Economic Cooperation and Development (OECD) has been stagnant or declining for more than a decade, oil consumption in non-OECD countries has steadily increased and is projected to surpass OECD consumption in 2014.

At the same time, S&P 500 companies are increasingly reliant on emerging markets for the growth in revenue and profitability that are the key determinants of equity values. The percentage of total sales of S&P 500 companies from sales outside the US rose from approximately 41% in 2003 to 48% in 2008. Since then, sales from Asia, Africa, and South America have continued to grow while the share of sales from Europe has declined. Movements in oil and equity markets in response to news regarding current and projected economic conditions in emerging economies are likely to remain positively correlated, due to the fact that both crude oil demand and the value of S&P 500 equities are increasingly influenced by economic activity in emerging economies.

However, past developments affecting the oil supply situation have lowered this correlation. Any future supply shocks, whether positive of negative, are likely to have a similar effect.

Adapted from a press release by Emma McAleavey.

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