Why on earth, when oil prices go down, the stock market is also going down? At first glance, it seems counterintuitive! When oil prices are low, it should boost the economy because energy is cheaper. So what is going on here? By the end of this post, you will understand what is happening.

You can also watch my video “OIL PRICE CRASH vs. STOCK MARKETS: Why falling oil prices drive the stock market down?” on my YouTube’s channel. Check it out!

When the oil prices are sharply down, like today, the stock markets usually perform poorly. This morning, the crude oil was down by 40%. And at the time I am shooting this video, the price is down by more than 90%. It is the largest one-day drop in history. At the opening, the Dow Jones futures were down by nearly 2%.

It may seem illogical at first glance. The economy suffers when oil prices are swiftly going up, not when they are going down!

Oil shocks

There are numerous examples in history; the most prominent ones are the two oil shocks of the 1970s. In 1973, the price of oil quadrupled, from $3 to $12 per barrel. Some oil-producing countries weaponized oil, and the targets were the United States, Canada, Japan, and some European countries. It caused the 1973-1974 market crash and had persistent consequences on the U.S. economy.

In 1979, the Iran-Iraq war caused a doubling of the price of oil. It triggered an economic recession in the US and around the world.

We also had the mini oil-shock of the 1990s, after the Iraqi invasion of Kuwait, and the S&P 500 dropped by 16% in the following months.

Medium-term and long-term effects of low energy prices

On the contrary, the medium-term and long-term effects of low energy prices are highly favorable for the economic output. Low prices of oil trigger or sustain economic growth, even if, in the long-run, it is terrible for the planet. So, stock markets should soar due to the potential future profits, don’t they?

Why stock markets fall in the short-term?

The issue faced by the markets is not in the long-run but the short-term. And it has four components.

Lower profits

First, low oil prices directly affect the companies in the oil sector, at best lowering their profit margins, at worst, causing losses. It is the first driver of the short-term drop of the stock market. Even large companies, like the behemoth Exxon Mobil, suffer. And smaller companies like Occidental Petroleum, are in real trouble.

The high-yield debt issue

Secondly, there is the high-yield debt. Oil companies emitted a lot of junk debt. They promised higher returns to attract more capital to develop shale oil production. Some of them were already stretched to the limit of their financial capacity before the coronavirus pandemic. In consequence, rating agencies cut credit ratings because of the effects of low prices on cash-flows. The new low in oil prices may trigger additional downgrades. Overall, investors in the high-yield bonds market have massive exposure to the energy sector, and combined with future downgrades, will cause the interest rates to go up for high-yield bonds. Higher borrowing costs, lowering investments and future profits, will then naturally trickle down to the stock market.

Sovereign wealth funds selling stocks

Third, sovereign wealth funds owned by oil-producing countries tend to sell stocks when oil prices go down. Some oil-producing governments are facing a double financial blow: less revenue and higher spending. At the end of March, a JPMorgan strategist estimated that those funds were expected to sell in total about $225 billion of stocks. This puts pressure on stock prices in the short-term. And don’t forget that the $225 billion figure was estimated before today’s oil price crash. It may be a higher figure in the end, especially since stock markets have rebounded from their low point in March, it is less painful to sell now than one month ago.

Leading indicator of the economic cycle

Finally, plummeting prices of oil indicate real problems in the economy. It means that the demand is nosediving and that the GDP is falling sharply.

Oil prices and investments

What are the impacts on your investments of oil prices dropping sharply? In the short-term, it is not good news. However, in the medium-term, it will help the economy to recover. It is essential to keep in mind that low energy prices are not causing recessions. That being said, we are not in standard circumstances here because we do not know when the economy will be able to restart. Due to the COVID-19 pandemic, we may face many months with anemic demand.

In conclusion, in general, it may be best to avoid energy stocks for a while. Their financial situation is deteriorating rapidly.

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Question of the day:
What do you think about the oil sector stocks and oil prices spiraling down?