Oil is Falling, Stocks are Rising

Well looks like the main story this morning is the price of oil. Oil has fallen to around the $64/barrel level. The oil inventory levels are supposed to be released today. I can only expect that if oil inventories are higher, the price of oil will fall. If the price of oil falls, then the markets in general should rise.

So what is this effect of oil prices on the stock market? Why is the price of oil so important to the stock market?

Well the most obvious effect is on the stock prices of the oil companies. When the price of oil rises, the profits of the big oil companies rise, since it essentially costs the same to pump oil out of the ground. Because profit/earnings is such a large component of stock prices, as profits rise so to do stock prices of the oil companies. All one needs to do is to go to Yahoo finance and take a look at a multi year chart of any oil company and see what has happened to their stock price over the last few years.

The second effect on stock prices that a rise in the price of oil has is on the transportation sector. As should be fairly obvious oil is a major cost for companies like airlines and trucking firms. Any company that has fuel as a major component of its cost structure will see their costs increase and their margins fall. Remember that earnings are such a large component of stock prices that as earnings decline so to do stock prices (all things being equal). This is especially true in a highly competitive industry. So any industry that has oil as a cost factor will have likely seen a decline in their earnings and the price of their stock as the price of oil increased over the last couple of years.

We also can’t forget about the general effect on the price of oil. Rising oil prices lead to rising gas prices. Rising gas prices are not only a component of inflation, but also a major part of people’s lives. People find themselves paying more for gas to get to work and go on family trips. Paying more for gas leaves people with less disposable income to spend. It also makes people think twice about going out of town for the week-end when the otherwise might have. Oil prices therefore have an effect on consumer spending.

Rising oil prices also contribute to inflation. Since it is a stated goal of the North American Central Banks to keep inflation in check, rising oil prices can also cause interest rates to rise if the Central banks perceive inflation too be rearing it’s head. If the Central banks increase interest rates, consumer spending will decline as the cost of borrowing increases. The housing market will start to slow. Interest bearing securities become more attractive to investors. All these factors combine to cause a general decline in the market.

This of course is a very simplistic and basic view of how I see things. I’ll keep my fingers crossed that the price of oil continues to decline; both as a consumer of oil products and as someone who is trying to make a buck in the stock market. More on this later.

Good luck and happy investing.