Crude oil is considered to be one of the most important commodities in the global economy. It is versatile in its uses and helps industrialize economies. A variety of things from plastics to rubber and machinery uses crude oil or its byproduct, making it a crucial element in the raw materials for many businesses in the economy.
Hence it is no surprise that the stock market is often influenced by the price of oil. It can affect an individual investor or have a domino effect on the stock market. Here are some of the ways oil prices affect the stock market:
How do oil prices affect the stock market?
– Profitability of oil companies
The oil business has two main components to it, the upstream and downstream business.
The upstream business is involved in the drilling of oil wells and the manufacture of crude oil in industries. Examples of such businesses include Oil India and Shell. When these companies are profitable it usually results in high stock market prices because the crude oil manufactured by these companies is the raw material for many businesses.
If upstream companies find it hard to drill for oil and face an increase in research and development costs, it could have an adverse effect on the value of the oil company’s stock.
The second type of oil business is the downstream business. These are corporations involved in the distribution and retail function of crude oil. They are in control of your local gas stations such as Indian Oil and Bharat Petroleum. These companies find low crude oil prices beneficial as they can now purchase crude oil at a low price from upstream companies.
– Consumer Demand
Almost everything that a person consumes is tied to oil such as electricity or fuel for their cars.
An increase in the price of oil can raise the daily living costs for people, reducing the amount of money they have available to spend on other goods and services such as electronics or clothing. The revenue of these companies decreases as consumer demand for their goods and services falls. The negative effect on the earning of firms lowers the value of their stock.
Alternatively, a decrease in oil prices has the opposite effect. When consumers spend less on fuel, it gives them more money for other goods and services. The increase in demand raises earnings and has a positive impact on the stock market.
– Profitability of other industries
Since all businesses use a byproduct of oil, an increase or decrease in the price of oil can indirectly affect them as well.
If the price of oil increases, a delivery services company will face higher fuel costs. These costs will be translated to consumers as high prices for their services. The low earnings of the company will result in low stock prices for the industry.
Likewise, if oil prices decrease, the companies can charge lower prices to consumers and have high profitability and higher share prices. In reality, however, companies rarely lower the prices of goods and services if the price of raw materials has decreased.
– Impact on Inflation
The price of oil can directly or indirectly increase or decrease costs of goods and services in the economy and can result in inflation. In the United States, the price of oil is not considered a factor when the inflationary rate is calculated but its price can cause a ripple effect in the economy through industries that use crude oil as a raw material.
If oil prices rise, it can increase the cost of living for individuals, putting a pressure on wage rates to make up for this. The high labor costs increase the costs of goods and services and increase the rate of inflation in the economy as each dollar can now buy fewer goods and services. When inflation rises the stock prices of the industry decline.
– Effect on Imports
For countries such as India that import almost 80 percent of its crude oil, a decrease in the price of oil is beneficial because it decreases imports expenditure and stabilizes the exchange rate of the currency.
However, a reduction in oil prices isn’t always great for the stock market. There is a positive relationship between the Foreign Direct Investment and the price of oil. When the price of oil goes up, oil-rich countries invest in emerging oil markets like India. However, when prices go down, they withdraw their investments.
Hence with a fall in oil prices, few foreign investors will invest their money in the Indian stock markets resulting in a negative impact on stock prices.
The versatility of the crude oil has made it an influential factor in the increase and decrease of stock prices. The price of oil not only affects the stock of oil companies but also the stocks of industries that use it a byproduct of it.
While the exact amount of influence it has on stock prices cannot be calculated, the price of this commodity can increase or decrease the total costs of production of many goods and services. This can affect the amount of goods people consume to exchange rate and the level of foreign direct investment which collectively affect the stock prices in an economy.
Needless to say, the price of crude oil has the ability to affect the level of investment in the economy and influence stock prices.