Some equities market investors might never have intended to follow crude oil and may not know the Permian Basin from the Bakken Formation. But with stocks currently closely linked to crude oil prices, investors need to understand how this correlation can affect trading and gain insight about what factors can and have moved the oil market.
The correlation between oil and S&P 500 futures recently reached a higher-than-normal 84%, said JJ Kinahan, chief market strategist at TD Ameritrade. But that was actually down from the extreme high of 92% seen in late January and early February. Historically, Kinahan said, the correlation has been 55%.
What does this close correlation mean for retail investors?
“It means you’re probably trading crude oil derivatively whether you think you are or not,” Kinahan said. “It means you should consider keeping crude oil on your watch screen and understand what it’s doing because it may affect where you put in bids and offers.”
For instance, Kinahan said, in this environment, someone buying an equity might have to be more aggressive and willing to pay a higher price if oil is driving the market up. On the other hand, if weak oil is pulling the equities market lower, an investor who wants to sell an equity may not need to be as aggressive to the downside.
Beyond the Charts: Where to Find Crude Oil Data
Many equities market investors read daily news stories about the oil market, but to get a deeper sense of the fundamentals, it’s useful to dig into recent reports from the International Energy Agency (IEA), which are closely watched by equities traders. For instance, the IEA’s Medium-Term Oil Market Report, released on February 22, helped send oil prices up 7% and gave the stock market a boost as well.
It’s also a good idea to be aware of and plan for regular industry and government reports that impact oil prices, including the Baker Hughes weekly oil rig count data, released at 1 p.m. ET each Friday; the American Petroleum Institute’s weekly statistical bulletin, released at 4:30 p.m. ET on Tuesdays; and the U.S. Energy Information Administration’s Weekly Petroleum Status Report, released at 10:30 a.m. ET each Wednesday.
Concerns About the “R” Word (Recession) Drive Correlation
Sam Stovall, managing director of U.S. equity strategy for S&P Global Market Intelligence, said the oil/equities market correlation has been high recently because of worries that slowing oil demand is a signal of a slowing world economy.
“It’s the ‘R’ word, recession, that people are really concerned about, and they’re wondering if a sharp decline in oil prices is a symptom of a slowing economy that could lead to a recession,” Stovall said.
Stovall thinks the strong correlation could start to unwind once oil supplies—now at record levels—come down.
“We’ll probably see the U.S., Canada, Britain, and Norway start to reduce output, which could bring the supply/demand situation back into balance,” Stovall said. “That could be the signal for a counter-trend rally and alleviate some of the concerns that we’re heading for recession.”
How to Track the Oil and Stock Correlation
Kinahan said that once the market has a better sense of where oil production is headed, the oil/equities correlation could dial back down.
“If you remember, there’s always something investors are focusing on,” Kinahan said. “Right now it’s crude, and when will that change? When we get stability [in the oil market]. It’s all in flux now. No one knows what production levels will be. When it stabilizes, then maybe investors will get back to trading the Fed or China.”
The IEA forecasts that by next year, world supply and demand will be roughly in balance, compared with a production surplus in 2015 of approximatey two million barrels per day. That could possibly be a sign of stability that would calm the markets and reduce this high correlation between equities and oil, though it’s too early to definitively say so.
One way that TD Ameritrade clients can track the correlation between crude oil and stocks is available on the thinkorswim® platform. The Correlation study measures the correlation between two instruments. It’s plotted from +1 to -1, where +1 is positive correlation and -1 is inverse, or negative, correlation. A reading of 0 means there’s no correlation. Figure 1 shows the correlation between crude oil and S&P 500 futures over the past year (see the line plotted below the chart).