Finance

Why Oil Matters (to Everyone)

With the average U.S. household spending approximately $2,000 per year to fill up their vehicle’s tank, most people know that the price of crude oil is the primary driver of gas prices. Those with a more sophisticated understanding of energy might also be able to connect oil prices to things like plastics, asphalt, or the macroeconomic health of oil-rich states such as Texas and North Dakota.

What’s often missed, though, is why the price of oil is important to the energy spend of the most eco-conscious individual — and why the real impact has nothing to do with travel. Instead, it’s a story of correlations and close connections that tell us why going green shouldn’t mean ignoring black gold. That’s because oil prices have an indisputable link to three things that, when combined, impact everyone: equities, exchange rates and electricity.

Starting with stock prices, it’s pretty clear that the results of an OPEC meeting are more important in predicting U.S. markets than Apple’s earnings call. Since the beginning of 2016, global crude prices have held an 85 percent correlation to the Dow Jones Industrials index. There are several reasons for the tight bond. On one hand, the stock market can help boost oil prices, as a bullish market would likely be linked to an improving outlook for gasoline demand or the like.

But in many ways, the story is that crude prices can actually guide the market’s movement. This can occur directly as rising oil prices lift energy stocks, or indirectly as increasing prices boost employment rates in major economic centers such as Houston. While the specifics of why the correlation is high at any given time are open for debate, the fact that the two are linked is simple mathematics. With that in mind, few companies would claim to be entirely unaffected by the moves of the market.

Oil Prices

Oil prices and the stock market have charted a similar path throughout 2016, holding roughly an 85 percent correlation

Of course, it would be exponentially more difficult — i.e., impossible — for any business to claim it’s not affected by the value of the U.S. dollar. See last year, for example, when almost every stateside corporation cited a strong dollar as a cause for disappointing earnings. Meanwhile, European businesses with revenue streams in the States often outperformed due to the preferential exchange rate. In short, money matters. This much we know.

Still, what does oil have to do with it?

To answer that question, it’s useful to look once again at correlation. The dollar index measures the strength of this legal tender against a basket of major currencies such as the euro, yen and pound. The dollar index and the price of oil have maintained a monthly inverse correlation of greater than 70 percent going back to 2010. As discussed in a previous article on central banks, the fact that crude is traded throughout the world in U.S. dollars means that when the value of the dollar goes up, the price of crude goes down. This is largely the result of basic supply and demand, since a stronger dollar makes oil more expensive in other currencies, which in turn lowers demand and the corresponding price of oil.

oil prices 2

The price of oil and the value of the U.S. dollar have long maintained an inverse correlation; the dollar’s gain has been oil’s loss

However, “largely the result” doesn’t paint an accurate portrait. There are more complex components of modern economics in play, which revolve around trade. Oil demand in the States is only slightly elastic since a 50 percent increase in prices wouldn’t cut the need for oil in half. Because the U.S. is still the world’s leading oil importer, a surge in the price of oil has substantial impact on widening the country’s trade deficit. Wider deficits translate to weaker currency, which means shifting the real value of every dollar-denominated bottom line.

For most companies, there is a third reason to care about oil. And it’s an entirely different fuel source — natural gas. In the U.S., the shale boom has lifted domestic natural gas production in recent years, lowering prices and allowing natural gas to overtake coal as the primary source of electric power generation. While natural gas can be a highly profitable business, it is often the byproduct of efforts to drill for oil. As a result, many producers aren’t using the price of natural gas to determine where they’ll breakeven. That factor rests mainly with the price of crude oil and crude-connected natural gas liquids.

The long-term domino effect goes something like this: Oil prices fall, causing oil production to fall, causing a decline in associated gas production in key areas, which leads to more expensive natural gas. Because gas is used to power generators across the country, the final domino is a spike in electricity prices and larger utility bills.

Due to these well-established connections, shifting oil prices affect all organizations, even if they don’t consume a single drop of crude.  While some industries may be shielded from the rise and fall of gasoline or diesel prices, none exist beyond the reach of markets, currency and electricity.

The risk is absolute, but reaching that conclusion and managing volatility isn’t a given for companies. Those that take action can protect and increase dividends.

Interested in learning more? Read our Energy Market Watch , and find out more how we help our clients buy energy strategically.

Contributed by Robbie Fraser, Commodity Analyst, Schneider Electric

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