One of the things in the news that I’m asked about is why low oil prices would hurt the stock market. Here are two recent headlines:
“World markets plunge as oil drops below $27 a barrel”, CNN Money 01/20/2016
“Dow jumps 200 as oil surges”, Yahoo Finance 02/22/2016
Our natural inclination is to expect falling energy prices to be good all-around because it means more money in the pockets of consumers. There is obvious truth to that – eventually. As the cost of living falls over time due to technology, workplace efficiency, discovery of natural resources, improved agriculture, etc. we all become better off. Lower prices create wealth.
In the last 18 or so months, the price of a barrel of oil has dropped approximately 70%. This was very much a surprise. As a result, countries, corporations and people that sit on oil reserves have just lost approximately $120 trillion dollars of wealth in a rather short time. That’s simple math using the world’s known oil reserves. Think about Saudi Arabia, Venezuela, Iran or any well-known oil company. Think about Canada. Venezuela is now printing money so fast to cover its commitments that inflation has soared above 180%. People are being laid off wherever revenues no longer meet expenses. Spending is frozen. Economic activity across the energy producing segment of the world economy is upside down.
You might think that there is no loss until or unless that oil comes out of the ground and is sold. So the $120 trillion is just a “paper loss”. Big deal. But think about how your behavior might change if your personal home and your 401K just lost 70% of their value. You would be stunned and worried. As a result, you might not remodel your kitchen. You might even stop going out to dinner as often. Knowing you have money in the bank (even if not spent) leads to different behavior than suddenly a lot less money in the bank. And if you or your company or your country depend on higher prices to cover loans you or they took out, there’s trouble.
Of course, prices may recover. Then again, they may not. There is a lot of opinion and not much consensus. According to the Institute for Energy Research, the U.S. has overtaken Saudi Arabia and Russia has the world’s largest oil and natural gas liquids producer. Energy appears to be very abundant.
However, there is clearly a short term effect and a long term effect. Longer term, wealth is created when essential goods become abundant and cheap. But it will take time before the world adjusts and starts spending its energy savings. Over the short term, just realize that if $120 trillion of wealth goes up in smoke suddenly for ANY reason, that will have a depressing effect on spending, consumption and the world economy.
Realize also that any surprise that disrupts or depresses the world economy will depress the stock market.