Oil and stocks - these two asset classes dominate global trading activity and business news headlines. West Texas Intermediate (WTI) crude oil prices provide insights into energy markets, while equity indices like the S&P 500 reflect expectations about economic growth and corporate profits.

Though traded in distinct markets, the prices of WTI and equities exhibit a complex interrelationship driven by macroeconomic forces.

Read to understand the correlation between crude oil and stocks for investors seeking to evaluate portfolio exposures and identify trading opportunities.

How Do Oil Prices Influence Equity Valuations?

As an input cost for many sectors, the price of WTI crude oil directly impacts company earnings. Rising oil prices increase production and transportation costs for manufacturers, retailers, airliners, shippers, and other segments. This causes profit margins to decline, negatively impacting valuations in the equities markets.

At the same time, higher oil prices also influence consumer behaviour. When gasoline and heating costs rise, households have less disposable income for discretionary purchases. Reduced consumer spending further dampens businesses' revenue and profit outlook, dragging down their stock prices.

Beyond direct costs and consumer spending, an increase in oil prices also fuels inflationary pressures in the economy. This causes the Federal Reserve to tighten monetary policy by hiking interest rates to control inflation.

Higher interest rates make borrowing more expensive for companies and decrease the present value of future cash flows. This macroeconomic impact further weighs on equity valuations.

Conversely, a decline in WTI crude prices boosts company earnings and stimulates consumer discretionary spending. Lower oil prices also give the Fed room to adopt accommodative monetary policies. These factors allow equity valuations to expand during periods of softening oil prices.

Give this article a read: How Shale Oil Production Affects WTI Prices

How Do Equities Impact the Oil Market?

While oil prices strongly influence equities, the reverse relationship also exists. Equity market trends signal changes in economic growth expectations, impacting the outlook for oil demand.

Rising stock prices typically reflect improving sentiment and optimism about the economy. Stronger economic growth leads to greater energy consumption, boosting demand for crude oil. However, falling equity prices often foreshadow deteriorating business conditions and potential economic contraction. Weaker demand outlooks then weigh on crude oil prices.

The equities market also impacts oil supply dynamics. When stock prices are depressed, shale oil companies see their access to capital markets squeezed. This restricts their ability to finance new drilling and constrains oil supply growth.

Moreover, low equity valuations make it harder for oil majors to sanction new long-term projects. However, surging stock prices have the opposite effect, facilitating greater investment in future oil production.

Take a look at this article: Baron Oil Share Price Predictions

Quantifying the Correlation

The correlation between WTI crude prices and equity market moves can be statistically measured using historical data. Over the past 15 years, the correlation coefficient between the daily returns of WTI oil futures and the S&P 500 index has been around -0.2.

In other words, WTI oil prices and US equities generally trend in opposite directions, but the correlation is far from perfect. This is because while oil prices affect equities, stocks are also driven by many other company and sector-specific factors.

For example, technology shares may rise despite oil price gains due to positive news about the sector.

The correlation also varies over time, depending on macroeconomic conditions impacting both markets. During recessions, the correlation becomes more negative as oil and equities decline. But in periods of steady economic expansion, the correlation weakens.

Managing Trades with Oil and Equities

Traders employ a variety of strategies to capitalize on the correlation between oil and equities. Here are some of the popular methods you must try out:

Pair Trading

Taking opposite positions in WTI futures and index ETFs like SPY to benefit from convergence when the correlation dramatically widens. This involves shorting the outperforming asset and going long the underperforming one, betting that the prices will eventually revert to the historical relationship.

Spread Trading

Going long WTI and short an oil company stock when oil prices rise, but equities underperform. This capitalizes on the divergence by being long the crude price while hedging the equities exposure.

Options Strategies

Using options on oil stocks or call options on oil futures to hedge or profit from price divergences. Strategies like crude oil call options, equity index put options, and short oil stock options offer asymmetric payoff profiles.

The relationship also has implications for fundamental investors with long stock horizons:

Sector Allocation

Overweighting refiners and transportation stocks when oil prices decline and underweighting them when oil rallies. Cheaper crude inputs benefit refining margins, while pricier oil raises transportation costs.

Stock Picking

One potential strategy for stock picking is to target upstream oil companies and oil services providers when WTI prices are on the rise. This is because their revenues and earnings are directly linked to higher crude prices, making them potentially profitable investments during such times.

Here's an interesting read for you: Guide to Oil Spread Betting

Economic Analysis

The interplay between oil and equities provides insights into the macroeconomic environment:

• Rising oil prices and flat or declining equities signal stagflationary conditions of low growth and high inflation.
• Falling oil prices and strong equities suggest healthy economic expansion with low inflation.
• If oil and equities decline, it indicates accelerating economic contraction and recession risks.
• When oil prices and equities rally together, it points to overheating and unsustainable growth vulnerable to aggressive tightening policies.

Therefore, observing the relationship provides an additional data point for fundamental macro analysis of business cycles and monetary policy impacts.

The dynamic between the crude oil and equities markets goes beyond just oil's physical input role in the economy. It is also rooted in their sensitivity to economic demand shifts, inflation trends, and investor psychology.

You might also like to read: How Crude Oil and Currencies Correlate

Final Analysis

The complex interrelationship between WTI crude oil and equity markets provides traders with opportunities to generate profits through thoughtful analysis and strategic positioning. While oil prices strongly impact equities as input costs, stock market trends influence oil demand outlooks and production dynamics.

Although not perfectly correlated, understanding the macroeconomic forces driving oil and equities trends allows traders to capitalize on pricing divergences through pair trades, spread trades, and options strategies.

There is always more to learn about capitalizing on the oil-equities relationship, so traders are encouraged to continuously educate themselves and evolve their strategies as market conditions change.

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“When considering “CFDs” for trading and price predictions, remember that trading CFDs involves a significant risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be considered investment advice.”