Call crude oil the comeback kid. WTI crude oil futures posted a stunning rally from a decade low below $30 earlier this year to touch the $50 per barrel mark last week. A combination of supply disruptions and declining U.S. oil production fueled the strong and steady rally seen in recent months.
Consumers probably noticed higher gasoline prices at the pump over the long holiday weekend, but overall at these levels the strength in crude oil offers up more "positives than negatives" for the economy and stock market, says JJ Kinahan, Chief Market Strategist at TD Ameritrade.
Here are 5 reasons crude oil at the $50 level is a significant event for investors and the market.
1. Crude oil around the $50 level provides an underlying level of support to the overall market, including bonds and stocks, Kinahan says.
Rising crude oil prices also supported a strong recovery in oil drilling stocks, Kinahan adds. Some oil drilling companies found financing through the junk bond market. When crude was trading around the $30 level earlier this year, there were worries that such a low price could lead to a house of cards if those oil drillers defaulted, which could leak over into the broader bond and even stock market, Kinahan says.
2. Higher oil prices should help boost S&P 500 EPS estimates, says Sam Stovall, managing director at S&P Global Market Intelligence. The S&P 500 is currently in a profit recession due to oil prices. Stovall highlights key numbers for investors to consider.
In 2015, the S&P 500 Energy sector posted a 60% decline in earnings, causing the S&P 500 earnings to slip 0.7%, year-over-year. Excluding energy’s drag, S&P 500 earnings would have risen nearly 7%. Over the past 20 years, S&P 500 Energy earnings have had a 93% correlation with oil prices. At current levels, oil prices are nearly twice as high as they were at the February lows. Should Wall Street oil-price estimates climb throughout the year, so too should the growth rate for S&P 500 EPS estimates, Stovall says.
3. Rising oil gives the Fed more wiggle room to hike rates. Below-target inflation has been a factor holding the central bank back on additional rate hikes this year.
S&P Global Economics sees headline inflation hovering around 1.0% (year-over-year) through much of the summer, and then rising gradually toward the end the year to around 1.6-1.7%. "Inflation expectations are more important that actual inflation levels to the Federal Reserve in its rate-hike decisions. We anticipate that the economic data out before the June 14-15 FOMC meeting will be favorable and prompt the Fed to raise the target federal funds rate by 25 basis points at its June meeting," Stovall says.
4. Consumers may spend less. There is an old adage that for every sustained $10 increase in the price of oil, it removes approximately 20 basis points of real GDP growth, Stovall says. "We think a sustained increase in oil prices will put pressure on consumer spending expectations."
5. Crude oil prices could pull back from here. S&P Global Market Intelligence projects oil prices to average $38 for all of 2016, Stovall notes.
"We believe the fundamental pressure of over-supply continues to exist structurally, and is currently being overshadowed by ephemeral events such as wildfires and by exogenous factors like dollar weakness. We still expect another decline in crude prices before we start to embark on another push higher --probably in 2017," Stovall says.
"Also, we think non-OPEC production cuts will likely be replaced by rising production from OPEC, as OPEC attempts to increase their market share. As a result, we don’t see overall global supply coming down as much as current oil prices suggest," Stovall says.
There’s an argument to be made for stock traders to track the price of crude oil. The correlation between crude oil futures and S&P futures is nearly 75 now, Kinahan says. It’s down from 92 earlier in the year, but there’s still a very clear correlation to the stock market, he notes.
TD Ameritrade clients who are trading crude oil futures can utilize the Active Trader Ladder tool, which shows depth of market and allows traders to quickly enter and change orders. See figure 1 below.
To apply the Active Trader Ladder, log into the thinkorswim platform and click Trade > Active Trader. Once you are in the Active Trader tab, type the symbol “/CL” in the symbol box in the upper-left corner and press enter.