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Stock market plunge: Why oil matters

October 15, 2014, 8:03 PM UTC
Massive Oil Slick Threatens U.S. Gulf Coast
GULF OF MEXICO- MAY 6: Oil burns during a controlled fire May 6, 2010 in the Gulf of Mexico. The U.S. Coast Guard is overseeing oil burns after the sinking, and subsequent massive oil leak, from the sinking of the Deepwater Horizon oil platform off the coast of Louisiana. (Photo by Justin E. Stumberg/U.S. Navy via Getty Images)
Photograph by U.S. Navy/Getty Images

Oil is proving to be a much bigger slick for the stock market than most people assumed.

On Wednesday, the Dow Jones Industrial Average fell, dropping nearly 500 points at one point in the day before recovering. The move seems at least in part to be driven by oil prices, which are also falling. And that is odd. Typically, a drop in oil prices is thought to be good for the market and economy. It lowers production costs, and, when it makes its way to the pump, puts more money in consumers’ pockets.

For instance, back in 2008, before the economy had cratered, there was a wave of worries that high oil prices, at that time around $150 a barrel, would be bad for the stock market. So why is the opposite happening now?

The answer, it turns out, is that, over time, the correlation between oil prices and stock prices is pretty weak. A few years ago, Andrea Pescatori, an economist who is now at the International Monetary Fund, tried to measure the relationship between oil and stock prices. He basically wound up throwing up his hands on the matter. Sometimes oil prices follow the stock market and vice versa. And sometimes they head in opposite directions. Recently, the relationship seems to be a positive one, meaning the two have been moving together.

WTI Crude Oil Spot Price Chart

Indeed, it appears that oil prices, which began to fall in June, are dragging down the market. Why would that be?

First of all, cheaper oil is less of a boon for the economy than it used to be. That’s because the U.S. imports and consumes less oil. In part, that’s because of fracking, but more efficient cars on the road are playing a part as well. That means lower oil prices deliver less of an economic boost than they used to, though it still should be a boost.

Pescatori also found that stock prices tend to follow oil prices when people are nervous about the economy. And that’s been the case for the past few years. Right now, the drop in oil prices appears to be happening on account of worries over global growth. Those same fears have spooked the stock market. The fact that they are moving together means that, despite 4% growth in GDP in the second quarter and generally positive jobs reports, investors are still nervous about the U.S. economy.

“If you think oil prices are dropping because the global economy is sick, then you are less likely to see lower prices as a windfall,” says Ethan Harris, Bank of America’s chief U.S. economist. Harris says he thinks lower oil prices are a function of increased supply and not a fundamental problem in the global economy. As a result, he thinks lower oil prices will offer a far more powerful boost to the U.S. economy than any drag we may get from Europe or elsewhere.

But the market isn’t seeing it that way. “Europe and Japan will be slow, but we have known that for a while,” says Harris.

In the end, the biggest reason oil prices are dragging down stocks may have to do with stocks themselves. Up until a month ago, with stocks prices hitting new highs, the market seemed to be priced for perfection. And when that’s the case, anything can upset the market, even when it shouldn’t.