Energy companies only account for 0.78% of the Nasdaq Composite and 2.7% of the Dow Jones Industrial Average. Even the more concentrated Russell 2k Small Cap Index only contains 4.9% energy stocks.
Despite these small percentages, all three indices dipped into correction territory this year alongside a rapid increase in oil prices. This raises the question: How does a commodity that represents such a small slice of the stock market have the power to influence your entire portfolio?
Oil is the Lifeblood of the Economy
To understand oil’s influence on your portfolio, first understand the interconnectedness of global oil production and distribution. The global oil trade is incredibly complex, as evidenced by the fact that the U.S. imports approximately 8.51 million barrels per day from 86 countries and exports 10.15 million barrels to 173 countries.
This interconnectedness is one byproduct of an increasingly globalized world, and it is a double-edged sword. A global market allows for efficiency in a stable economic climate, but it also means that disruption in one area of the world can have ripple effects across the globe.
For example, sanctions following the invasion of Ukraine removed Russian oil from U.S. and European markets. Consequently, the supply of oil was constrained and prices spiked above $100 per barrel.
How Oil Prices Impact Your Stock Holdings
Rising oil prices impact businesses unevenly, so they also impact your stock portfolio unevenly. Some companies profit from pricey oil while others feel the strain.
Stocks for Energy Producers Can Rise with Oil Prices
Companies that produce and sell oil often see an immediate boost in their stock price following a spike in oil prices. This means they can sell oil at a higher price while their costs might remain relatively constant, which equates to higher profit margins.
Just a few weeks ago, this effect was evident with energy giants ExxonMobil and Chevron. The day before the initial attack on Iran, February 27th, ExxonMobil’s stock price was $152.50 and Chevron’s was $186.76. Throughout the following month, ExxonMobil gained 12.12% with a stock price of $170.99, and Chevron gained 13.06% with a price of $211.15.1
Other Stocks Can Fall When Oil Prices Rise
For companies outside the energy sector, rising oil prices generally have a negative impact on profit margins. For example, the manufacturing and chemicals sectors are directly impacted by oil prices. These companies often use petroleum as an input, so higher oil prices raise the cost to produce products.
Transportation costs are also directly influenced by oil and gas prices. This impacts travel companies, such as airlines, on-site service providers, and businesses that move products.
Further, transportation and freight costs indirectly affect the entire chain of companies involved in producing consumer goods and delivering them to customers. The increased shipping costs raise the price of moving raw materials to manufacturers and the price of delivering goods to distributors, stores, and consumers – creating a double sized impact on some products.
Companies impacted by higher oil prices have two options – absorb the costs or pass them to consumers. Businesses often absorb the costs for a short period of time – attempting to weather the storm. However, the longer oil prices remain elevated, the more likely businesses are to raise their prices permanently.
Expectations Vs. Reality
Stock markets are forward-looking, meaning that investors often trade based on what they believe will happen rather than what has already happened. Consequently, stock prices often drop when oil prices rise – often based on fear of declining profits rather than concrete evidence of what the underlying businesses are actually experiencing. Then, stocks may improve when the initial fear-based trading is done, even if nothing has changed in the oil markets.
Overall, a rapid increase in oil prices typically occurs alongside a sharp drop in stocks for those companies outside the energy sector. This may ease as fear recedes, but the depth of the contraction and the length of time stock prices remain subdued can vary widely based on the extent and duration of elevated oil prices.
Oil Prices Impact Inflation, Interest Rates, and Your Bonds
Increasing oil costs are often a key driver of inflation. This is particularly apparent when oil prices remain elevated for an extended period, as companies will generally pass the cost increases to their customers.
When inflation rises consistently, the Federal Reserve typically steps in to improve price stability. Their most commonly used tool is the Fed Funds Rate, which serves as a loose baseline for other interest rates, like those on loans, bonds, and cash investments.
For your portfolio, a scenario of persistently high oil prices generally leads to increased inflation, increased interest rates, and higher bond yields. Since bond prices and yields are inversely related, an increase in yields for newly issued bonds decreases the sale price of bonds you currently hold. On the other hand, you could earn more income from purchasing bonds issued at the higher rate.
Your cash holdings can also be impacted by higher oil prices, though more indirectly. Higher inflation and interest rates generally lead to higher yields for money market mutual funds, and eventually higher yields for bank accounts. However, pay close attention to the yield you receive on cash, because inflation erodes the purchasing power of your cash. This means a 2% yield on cash when inflation is higher than 2% results in declining purchasing power for your cash.
The Downstream Economic Impact of Higher Oil Prices
While your focus is likely on your own portfolio, higher oil prices can also affect the broader economy. Higher gas prices act as a functional “tax” on households, increasing their monthly outlays at the gas pump. In turn, that is money that isn’t being spent on goods and services.
This reduction in discretionary spending can hamper the entire economy. If prices keep rising while growth slows, the country can enter a phase known as stagflation. This challenging environment was seen in the 1970s amid perpetually high gas prices and stagnant growth.
In your own life, the impact of higher oil prices can be seen in two main areas – your monthly budget and the purchasing power of your savings. Your monthly outlays on gas may increase, which leaves less room for other purchases. Similarly, oil-related inflation could raise the price of your frequent purchases, further tightening your budget. Finally, inflation can erode the purchasing power of your savings, requiring a higher rate of return to maintain the value of your portfolio.
The broad economic impacts and the possibility of long-term inflationary pressures are not always a concern when oil prices rise. Instead, these negative outcomes usually surface when oil prices rise and remain elevated for an extended period. There have been many times throughout U.S. history that oil prices rose for a short time and had a similarly short-lived impact on the economy and stock markets.
Oil Shock Vs. Oil Crisis: Where Are We Now?
An “oil shock” occurs when energy prices spike and cause a short-term economic disruption that doesn’t produce significant, lasting effects. A longer-lasting “oil crisis” occurs when oil prices rise significantly and remain elevated for an extended period. This is the case when inflation, higher interest rates, and economic contraction become concerns.
Today, oil prices have been on the rise for a little over a month. It is too soon to tell if the current situation is a temporary shock or a more enduring inflationary event. In either case, diversification, discipline, and the support of a financial advisor are key to helping you navigate the changes.
Navigate Rising Oil Prices Confidently with Financial Fingerprint®
At Meld Financial, we understand that watching your portfolio fluctuate due to global oil markets can be unsettling. Fortunately, our team is here to help you look past the daily headlines and focus on long-term financial success.
We support your financial health with a comprehensive wealth management program called Financial Fingerprint® that is tailored to your specific goals and tolerance for risk. We created this program to help families navigate shifting economic and energy cycles, and we’ve been honing it since 1975.
Give us a call today to learn how Financial Fingerprint® can help you navigate a shifting economy with confidence.
1Data source for stock quotes: Yahoo Finance
