How Oil Prices Affect Your Portfolio?

24 February 2022

Stock markets are notorious for being highly sensitive to several factors like policy announcements, interest rates, exchange rates, economic stability and so on. Out of these, one major factor is global oil prices. Stock markets are extremely volatile when it comes to the reaction to crude oil prices and fuel prices in different markets across the globe. Read on to find out about how they affect the stock market and how they matter to your portfolio.

A Brief History

Between January 1973 and December 1974, almost all of the world’s major stock markets, especially the UK, suffered a bear run. This was considered to be the worst stock market downturn since the Great Depression. While there were other factors too, the Oil Crisis which began in October 1973, caused oil prices to rise and was one of the major reasons contributing to the stock market crash. This is the most notable example of how oil prices affected stock markets.

More recently, the derivatives contracts of crude oil went into the negative in April 2020, on the back of the excess supply (no buyers for the futures contract) due to the outbreak of the virus. Oil demand fell steeply as the entire world went into a state of lockdown. Despite the fall in demand, producers did not halt oil production in time, hoping that the demand and oil prices would surge again. 

However, that did not happen. And oil prices crashed in the negative (WTI crude oil). 

Despite this landmark event in oil prices, the NASDAQ index was hardly affected and only decreased by 16 points in that week. It further decreased in April but bounced back by mid-May.

Effect on Stock Markets

Although there are a few instances where heavy fluctuations in oil prices were accompanied by stock market swings, some recent studies suggest that oil prices hardly have an effect on the stock market as a whole. In this case, correlation does not equal causation. 

Generally, market indices like NASDAQ, NIFTY 50, BSE SENSEX are unaffected when oil prices fluctuate. This is because oil companies and other companies which are heavily affected by oil prices form 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:

  • Increase in Input Costs: Oil is a major input for several industries. When crude oil prices rise, naturally, input costs and overall production costs also rise. This causes profit margins to fall which in turn reduces the stock price of that company. Conversely, a fall in oil prices produces the opposite effect. Airlines, refineries, logistics, paints and other such companies are the most affected in such situations. 
  • Current Account Deficit: For every US $10 increase in the cost of oil, the current account deficit increases by 0.55%. This is because oil accounts for a large portion of India’s total imports. Whenever the current account deficit increases, foreign exchange starts flowing out of the country. This leads to the depreciation of the rupee. This means that imports are now costlier as the government will have to pay more to get the same quantity as before. As imports become more expensive, input costs increase and the stock prices fall again. Conversely, if oil prices decrease, the opposite will happen. Imports will be cheaper and stock prices will appreciate.
  • Increase in Transport Costs: Increase in crude oil prices means that transport costs will increase which in turn will increase the costs that the company has to bear. Again, this implies reduced profit margins and a decrease in stock prices. Conversely, a fall in oil prices will cause stock prices to increase.
  • Increase in Inflation: For every US $10 increase in the price of oil, the Consumer Price Index (CPI) increases by 0.3%. When inflation increases, investors’ confidence in firms goes down and negatively affects the stock prices. Conversely, a fall in the price of oil boosts investors’ confidence and positively affects the stock prices. 

Takeaway

While the stock market as a whole may not fluctuate violently due to changes in oil prices, some heavily oil-dependent companies certainly are. So take note of crude oil price movement before investing in such companies.

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