Why do oil prices and stock markets diverge?

For most of this admittedly still young year, oil and the broader stock market have moved in opposite directions. Crude futures (CL), even after a few days of declines, yesterday ended around 12% higher than they were at year-end, while the S&P 500 was around 6% lower than December 31, 2021. That’s a big difference from just three weeks, so why is this happening and, more importantly, what does it mean?

There are many reasons why these two markets could move in opposite directions for a while without being particularly noteworthy or significant. The most obvious is that the price of crude has a supply element and that supply dynamics can change for a number of reasons. There could be a concern or reality of a temporary interruption of production in a geographic area due to war or natural disaster, for example, or there could be an OPEC-type agreement to restrict the crude production in order to influence prices.

Both of these apply to some extent to the current situation, but neither fully explains the disparity.

Geopolitically, there is some nervousness about the Russian presence on the Ukrainian border, but as a Ukrainian friend pointed out to me the other day, Putin’s troops have been “massing” on that border for about eight years now. That doesn’t mean there won’t be a crisis this year, but it does put the chances of a crisis in the near future into perspective. And, as you surely know, OPEC+ has an agreement…

For most of this admittedly still young year, oil and the broader stock market have moved in opposite directions. Crude (CL) futures, even after a few days of declines, ended around 12% above their year-end level yesterday, while the S&P 500 was around 6% lower at that of December 31.st, 2021. That’s a big difference in just three weeks, so why is this happening and, more importantly, what does it mean?

There are many reasons why these two markets could move in opposite directions for a while without being particularly noteworthy or significant. The most obvious is that the price of crude has a supply element and that supply dynamics can change for a number of reasons. There could be a concern or reality of a temporary interruption of production in a geographic area due to war or natural disaster, for example, or there could be an OPEC-type agreement to restrict the crude production in order to influence prices.

Both of these apply to some extent to the current situation, but neither fully explains the disparity.

Geopolitically, there is some nervousness about the Russian presence on the Ukrainian border, but as a Ukrainian friend pointed out to me the other day, Putin’s troops have been “massing” on that border for about eight years now. That doesn’t mean there won’t be a crisis this year, but it does put the chances of a crisis in the near future into perspective. And, as you surely know, OPEC+ has an agreement in place to limit production. Again, this is nothing new and we are now in the period where restrictions are being systematically relaxed.

So, while there are bullish supply-side influences on Oil, they are not a surprise and alone do not explain such a sustained and strong rise in CL. For that to happen, there needs to be a positive demand outlook, and that’s where the disconnect between oil and stocks comes into its own. Both markets are sensitive to economic conditions and growth prospects, so what’s the right reading? Is the economic picture and outlook strong, meaning oil is right, or weak, meaning stock traders are reading better?

The correct, if somewhat unsatisfactory, answer to these questions is “It depends.”

It mainly depends on your schedule. Initial oil futures, by definition, look no further than one month. For this reason, crude is less influenced than equities by what the Fed may or may not do later this year, and right now the economy is strong. Unemployment is low and growth is decent. For stock traders and investors, however, even the thought of reversing the ultra-low interest rates that have done so much to create this situation and fuel the bull market is frightening. For oil traders, it’s something they will deal with when and if it happens. You can’t assess something that might happen in three to six months in a contract that expires in less than a month.

Still, the fact that longer-dated WTI contracts have kept pace with the initial rise suggests that the oil market is far more positive about the economy, both in the U.S. and globally, than traders in stock Exchange. History shows that when this type of dichotomy exists, oil traders are more often than not right, in part because of this imposed short-term outlook in oil. Stocks are dragged down by fear of what might happen; oil is pushed higher by what is actually happening…and in my experience, reality beats fear most of the time.

So as long as oil stays high, I’ll start nibbling lower stocks. Most of these investments will be for long-term investments, but I will also be looking for certain trades on the same basis. This morning, for example, I bought S&P E-Mini (ES) futures at 4425. I’m looking for a bounce above 4500 there and if it happens I’ll put a stop loss just in below 4450 with the aim of regaining yesterday’s level. high about 4600.

Given the intraday price action yesterday, that might not work out I guess, but I like my chances. Cl bounced a few dollars off the overnight low at 82.78 this morning and after initially looking like today would be another rout for stocks, ES followed and bounced as well. It could well mean that stock traders are starting to look beyond their fear and understand the message sent by other growth-sensitive markets. If so, stocks are near the bottom of their decline and a rebound is imminent.


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Felix J. Dixon