Daily Risk Report: Oil, Stocks, And The Middle East

Daily Risk Report: Oil, Stocks, And The Middle East


Situation Today

With tensions rising in the Middle East following US military actions in Syria, markets have reacted with some significance. As is often the case with unrest in the region, the focus turns to oil. In recent days, the price of crude oil has risen by approximately 8% (since April 6, 2018). The main reason being potential disruption in production of oil in the region.

Chart^XOI data by YCharts

The S&P 500 has on the other hand been relatively unchanged, although daily movements have occasionally been notable.

Chart^SPX data by YCharts

As history has often shown, conflicts in the Middle East usually affect the commodities markets – especially, the market for crude oil. Given the situation described and recently rising oil prices, should investors – and perhaps primarily passive investors in the overall stock market – be concerned about the tensions in the Middle East?

Oil vs. S&P 500

To answer the question, it is helpful to look at historical data and how changes in the price of oil have affected or resonated with changes in the stock market. When looking at daily historical data from January 2, 1986, to August 31, 2017, it is clear that the price of oil has fluctuated significantly, especially in the last ten years – the commodities boom around 2008 being the most notable period of price changes, along with the sharp price drop in 2014, following increased production and supply changes.

oil s&p 500To provide a broad picture of the relationship between oil and stocks, it may be revealing to look at the correlation between S&P 500 and crude oil prices. As the graph below shows, there is a relatively strong correlation between the two (correlation coefficient being positive of 0.59) for the period in consideration.

oil s&p 2This means that when oil prices rise, one would expect the S&P 500 to rise as well, i.e. a rise in oil prices generally coincides with a rise in the stock market.

Oil Price Economics

However, one must recognize that oil prices can rise for two reasons:

  • Supply – “Supply shock”. For example, when geopolitical events cause a disruption in production and the supply chain. This is generally viewed as a negative with potentially rising inflation and higher input costs. The primary risk of such a shock is stagflation – rising prices with slowing economic growth (due to more costly and less profitable production).
  • Demand – For example, when demand for goods increases in a growing economy. This would generally be a “positive” effect, resulting from increased aggregate demand and positive economic growth.

In today’s case, we are witnessing a potential supply shock. Conflict and Middle East tension are more likely to affect the production side of oil and hence cause a rise in oil prices through a sudden decrease in supply.

Earnings And Interest Rates

The real question then is, “Should investors be concerned about rising oil prices due to tensions in the Middle East?”

With the value of companies defined as the present value of future cash flows, investors should consider the effects of higher oil prices (supply shock) on earnings and interest rates:

  • Earnings: In general, higher oil prices raise input costs, making production more expensive and negatively affecting profits. Although some companies benefit from higher oil prices (e.g. oil companies), the majority of businesses are hurt by higher prices with the effects being more severe as prices rise further and stay elevated longer.
    Today, we have only seen a modest increase in oil prices. Earnings are unlikely to be materially affected by a modest price increase, especially if it turns out to be only temporary. The main risk is that prices would continue to rise significantly and stay elevated for a long time. However, currently, we don’t see strong signs of that happening – the Syrian crisis has been ongoing for a long time already, and the military action is very concentrated. There is also the consideration of oil’s diminishing importance in the economy.
  • Interest rates: Higher oil prices raise the price level and cause a rise in inflation (unless it is a very temporary oil price increase). With higher inflation, one would expect the Fed to raise rates in response, but since a supply shock is generally detrimental to economic growth, raising interest rates would further harm economic output.
    Today, inflation is at a low level and not a problem (like it was e.g. in the 1970s). All else being equal, it is therefore unlikely that the Fed would respond to rising oil prices by raising interest rates. If the economy continues to blaze through an oil supply shock without showing any signs of slowing down while inflation starts rising, the Fed would likely begin to raise rates at a faster pace (but then, the reason would also be an expansionary economy rather than higher oil prices). Overall, investors should therefore not be particularly concerned about interest rates rising now in response to potential inflationary pressures due to higher oil prices.

Conclusion

When assessing the current situation – unrest in the Middle East, specifically with regards to Syria – it is hard to see how events there could dramatically impact global markets and economic/corporate fundamentals. Certainly, markets may experience temporary volatility, but the tension in the region has already been ongoing for a long time, and US military action is very concentrated with any unrest relatively unlikely to spread.

At this moment, with the tension still impacting oil prices, we don’t see any specific, identifiable signs to indicate a significant increase in the price of oil to a long-lasting elevated level (i.e. new and different signs that could cause serious and truly impactful price swings significantly beyond what the markets have seen in recent terms). There is no clearly identifiable reason specific to this situation that might justify such a significant and impactful supply shock. This specific situation is more likely to cause a moderate (and temporary) increase in the price of oil. As a result, general corporate results are unlikely to be materially affected. In addition, inflationary pressures are likely to be minimal with interest rates unchanged (with regards to this specific situation).

Overall, investors should therefore not be particularly concerned about the impact of current Middle East tension on general stock market performance but might be wary of any future signs that could trigger a significant increase in the price of oil to a long-lasting higher level.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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