Taking stock of oil’s spell cast over the world

Whether the oil plunge simply reflects an energy market correction or hints at a sea change in global trade, crude’s woes have seeped into seemingly unrelated equities. Here are four hypotheses on why.

New York Stock Exchange. Markets have been volatile since the price of oil fell dramatically. Richard Drew / AP Photo

Even casual observers know that oil is exerting uncommon influence on stocks. What is less clear is how the energy market has come to dominate sentiment in industries with seemingly no connection to crude prices.

Understanding why and how oil has mesmerised almost all of the markets is more than an academic inquiry.

The reason matters, given how big the moves have been. Almost $1.6 trillion has been erased from US stocks this year. If oil is contributing, it would be nice to know why.

Here are four theories on what is underpinning the connection. They range from a straight economic signal to speculation that oil’s plunge threatens to lay low everything up to and including the financial system.

None is authoritative – it can’t be – and it’s possible that something else entirely is only making it seem like oil and stocks are moving in lockstep. But these are the hypotheses most often cited by equity investors this week.

The economy

Theory: oil traders have sussed out information on the direction of the global economy and the plunging price reflects a world hurtling into a recession. US stocks have taken note, or have drawn the same conclusion on their own.

“Oil is a proxy for global demand and growth and there’s a real view that as prices move it’s reflective of the global economy,” says Michael Arone, the Boston-based chief investment strategist at State Street Global Advisors’ US Intermediary Business. “Who’s leading who is perhaps hard to tell here, but it certainly seems both are indicating concerns about the world economy.”

Sceptics would say oil’s fall is an overproduction issue. The demand side has yet to wane and signal a collapse in global growth.

Still, coupled with fears of China's shrinking appetite, bears persist in pinning oil's plunge to concern about demand. Credit

Theory: the price of crude underpins the value of so many corporate bonds and loans that its 57 per cent decline since June will ignite a crush of defaults that bankrupt hedge funds and banks. Energy makes up a fair portion of riskier bonds – 19 per cent of the Bloomberg High Yield Index, or $284.1 billion.

“The major risk banks have is not to their normal retail-oriented stuff, it’s to the oil space,” said Andrew Brenner, head of international fixed income at National Alliance Capital Markets in New York.

“Shale drillers and various oil situations have made up an increasing amount of high yield lately, and banks have lent a lot of money to energy, so you have the high-yield loop and you have the financials loop.”

Default rates in the oil patch could reach as much as 15 per cent this year, with the overall corporate default rate rising to 7 per cent, according to BCA Research in Canada.

That is almost double the pace of the mid-1980s, when a correction in the oil price sent energy sector defaults soaring. Furthermore, energy companies are on the hook for $190bn, or 2 per cent of all bank loans, according to BCA.

If prices stay sub-$30 per barrel, smaller energy companies that borrowed money to finance projects may be unable to repay their debt or funnel cash to shareholders.

There is fear of contagion beyond energy and financials – banks could react by tightening credit lines, thus magnifying the credit crunch. That fear fuels a broader sell-off in equities.

Investment

Theory: energy and commodity companies do so much hiring and building in the US economy and when they stop, earnings will suffer both within and outside of the industry.

“The energy space was the fastest-growing part of the US economy post-financial crisis, and now it reverses. Businesses are shuttered and people are laid off,” said Nick Sargen, chief economist and senior investment adviser for Fort Washington Investment Advisors.

“There are some people beginning to worry that this thing could spread like the sub-prime crisis. People had said then that it was too small to matter, and then you find out there are linkages you didn’t know about.”

Although cheap oil is theoretically a boon to shops and restaurants, equities take a bigger cue from business spending, much of which is tied to commodities. In 2014, the energy sector accounted for nearly one third of S&P 500 capital expenditures, according to data compiled by Bloomberg.

The average energy company spent $5.7bn on capex that year, compared with an average $1.5bn in the overall index.

Jobs in fields such as drilling, fracking and rigs make up 0.4 per cent of total US employment, and 1.6 per cent of real value added, according to BCA Research. Investors are concerned that energy’s contribution to the US economy will evaporate as oil sinks, said Mr Sargen.

Pain trade

Theory: the world’s biggest investors are being forced to sell everything that is not nailed down to offset the hit they are taking on their crude holdings. After being pummelled in commodity trading, investors may be stepping into stocks and unloading.

“If you have a multi-asset portfolio and you’re looking to de-risk and you have problems in one sector, you will attempt to sell others to get your overall risk profile lower,” said Krishna Memani, the chief investment officer at Oppenheimer Funds in New York. “Credit markets were tanking, oil markets tanking and equities were at their highs so where do you go to reduce risk? You go to equities.”

One big seller may be oil-rich nations from the Middle East to Latin America, which account for about 5 per cent to 10 per cent of global assets. After years of using oil money to buy assets, now they are selling them, sending petrodollars pouring out of investment vehicles such as sovereign-wealth funds, stabilisation funds, development funds, and foreign-exchange reserves sitting in central banks. The gross flow of petrodollars into the global economy last year fell to as little as $200bn, down from nearly $800bn in 2012, according to Royal Bank of Scotland Group.

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