Understanding the Spike in Oil Prices
What oil’s rise means for markets
By: Johann Colloredo-Mansfeld and Igor Vasilachi
The COVID-19 crisis has seen oil prices collapse by 75% in Q1 2020, only to witness a stellar recovery afterward. Oil prices have since registered a record-breaking appreciation of 300%, doubling in the past 12 months alone. For context, oil prices have managed to double in a year only five times in 80 years of available data.
Should these oil price increases worry us? And what do they say about the future of our economy?
The view that increasing oil prices are bad for stock returns has long been a popular one. Oil is a critical input in the economy, both as energy and as raw production material, so rising input prices combined with sticky output prices can be a recipe for disaster. At face value, this intuition is compelling.
But the answer is more nuanced than that. In our essays “On Oil” and “The Best Macro Indicator,” we highlight that three-month forward returns for oil are highest when real GDP growth is rising (quadrants 1 and 2) and worst when real GDP growth is falling (quadrants 3 and 4). It therefore appears that oil is more a measure of the economic pulse than a driver of it.
In addition, it seems that business growth is stimulated enough in an expanding economy that it can absorb such price increases. In “The Best Macro Indicator” we also show that periods when oil prices rise are also periods when stocks tend to do particularly well and when high-yield spreads tend to fall. This positive relationship is particularly obvious in the regressions between equity returns and price changes (see below).
Figure 1: Contemporaneous Regression: Real Returns by Asset vs. Real Oil Price Change (1970–2021)
Source: Bloomberg, Capital IQ, Ken French Data Library, FRED
The positive relationship between stock market returns and oil price increases is even stronger for net oil exporters like Qatar and Norway. And we couldn’t find any market in which a negative relationship existed, even those countries where oil imports represent a large percentage of GDP.
In a nutshell, it appears that equity returns and oil prices are both primarily influenced by the business cycle. The two asset classes have a positive relationship, and both are pro-cyclical. As such, oil prices and equities tend to rise together when the economy is growing and fall together when the economy is shrinking.
The exception to this general rule is when oil price increases are driven by supply shocks instead of aggregate demand, such as when OPEC limited oil supply to certain countries in 1973. In these instances, the relationship between oil price and stock returns reverses. Below we show all instances when oil prices increased by 50% or more over a 12-month period in the past half century. This list captures all supply shocks that were categorized as such by media or academic sources. All instances when oil price increases occurred at the same time with a negative stock market return happened during supply shocks.
Figure 2: Annualized Average 12M FWD S&P 500 Returns by Shock Event
Source: Bloomberg, FRED, desktop research
Equity investors only need to worry about oil price increases if those increases are driven by shrinking supply, which tends to only occur during political unrest in the Middle East. Most oil price increases are driven by increasing demand and rising GDP growth and are a normal part of the business cycle, best considered in the context of a broader macro-economic analysis of GDP and inflation.
So what does that mean for investors in today’s market environment? Our high-yield indicator suggests the economy has gone through the initial recovery phase post-COVID (quadrant 1, rising GDP growth, falling inflation) and is now in a reflationary environment (quadrant 2, rising GDP growth, rising inflation). Oil price increases are therefore expected in such environments.
However, oil investors should pay close attention to short-term market moves, as there are two potential threats to returns. The first one comes from the business cycle itself. Should the economy transition into an environment of falling growth as inflation continues to rise (quadrant 3), oil prices might fall under the pressure of falling aggregate demand.
The second threat comes from mean reversion, as real oil prices have just crossed into the highest historical price quintile.
Figure 3: Historic Inflation-Adjusted (Real) Oil Price per Barrel (1973–2021)
Source: FRED
Oil is weakly mean reverting. High oil prices attract new drilling that in turn increases supply and brings prices back down. But this a weak relationship: high prices don’t signal much about future returns in and of themselves.
In sum, we think surging oil prices are primarily a barometer of extraordinary GDP growth and that investors should understand these price increases as a normal part of the business cycle. We think investors should only start worrying about oil prices when high-yield spreads start to widen out as growth slows, which is not the case now, as global economies recover from the pressures of the Delta variant over the summer.