Oil price spike - don’t fear 2023 highs

Oil price hikes tend to cause flutterings of unease for investors.

History tells us why. Nearly all post-war recessions in the US have followed or been accompanied by a sharp increase in energy prices. The major global sell-offs (including the 2000 dotcom bust and 2008 financial crisis) followed periods of strong energy price growth. And in the UK, market historians like to point to the Winter of Discontent, when energy prices surged following the Arab-Israeli war and markets sold off heavily. Even last year, oil prices played their part in investor malaise - strip out the strength of the oil and gas giants (which profited from the peak prices) and market returns were moribund.

The picture therefore appears clear: on both sides of the Atlantic, there is precedent for energy market woes spilling over into the stock market.

It makes sense that oil price spikes can cause challenges for listed companies. Rising prices make it more expensive to produce goods and services, driving down company profits unless management is able to pass on costs to customers. There is also plenty of research which supports the productivity fallout from an oil price surge. According to the International Energy Agency, a $10 increase in a barrel of oil means a 0.5% decline in global output the following year.

With production cuts from Saudi Arabia and Russia compounded by the atrocious conflict in the Middle East and its potential to spill over in to oil-producing nations like Iran, many investors are now on their guard. The price of a barrel of Brent Crude has surged 30% since June and looks set to return to triple digits for the first time in 2023.

This price change has been mirrored by the performance of FTSE oil majorsShell (LON:SHEL) (up 20% since June) andBP (LON:BP.) (+21%). Across the pond,Exxon Mobil (NYQ:XOM) (+14%),Chevron (NYQ:CVX) (+12%) andConocoPhillips (NYQ:COP) (+20%) have been in similarly high demand. Gold - a safe haven asset for troubled times - is also rallying.

And, as per the apparent historical precedent, the stock markets find themselves grappling with unwanted volatility. The S&P 500 peaked at 4,589 points at the end of July and has jolted downwards ever since. The Volatility Index (VIX), which enjoyed a restful summer, has started to tick upwards again. On UK shores, oil price rises have done nothing to support the beleaguered FTSE All Share, despite the relative strength of the oil sector.

But should investors really fret about the impact the surging price of oil could have on their portfolio?

The real cost of oil price surges

Research into the impact of oil price movements on global markets varies from uninspiring to inconclusive.

Bing Xu’s 2015 paper which concludes high oil prices have a positive impact on the returns of companies in the oil and gas sector feels like a bit of a waste of 44 pages. The study does redeem itself somewhat by reviewing other literature to confirm that large cash outflows during periods when the oil price is high has an out-weighted impact on companies in the consumer goods space - but that’s still not a hugely surprising revelation.

Studies into the impact of high oil prices on markets in general offer more intrigue, but they’re strangely indeterminate. For example, a 2008 Japanese study found global energy market dynamics have a strongly negative impact on the domestic market, while a paper published in the same year found that the opposite was true in Norway, where high oil prices have a statistically significant positive correlation with overall market returns.

Perhaps those conclusions should be obvious. Japan depends on the Middle East for about 90% of its crude oil requirements. Norway is a net exporter. Moreover, Japan’s economy has been anaemic since the early 1990s and research into the impact of oil on the macro-economy is far more confident than that which focuses exclusively on the stock market. According to James Hamilton’s 1983 study, oil price shocks were a “major contributing factor” in at least some of the pre-OPEC recessions and “by extension” energy price spikes are likely to have contributed to more recent periods of economic stagnation.

However, none of this answers the question: should UK investors be concerned about current oil price activity? And in truth, there is further to dig into the research before we arrive at an answer. Because academics like to talk about the difference between demand and supply shocks.

For example, if the oil price is surging because of a demand shock (for example, buyers bringing forward purchases because of fears about future production), stock markets tend to have a negative reaction. This makes sense. If companies which rely on energy are having to stock-up for fear of not receiving enough oil for their requirements, it is understandable that their profits (and share prices) will suffer. This supports a wealth of literature which has concluded that the major stock markets (including the UK and US) tend to sell off in the face of oil price spikes.

But, as Lutz Kilian and Cheolbeom Park point out in their 2009 paper, very few studies have assessed the underlying cause of the oil price spike when they draw conclusions. In fact they suggest that supply-side disruption has a far lesser affect on the performance of stocks than demand-side disruption.

For investors, this is all pretty unhelpful. At the moment, the oil price is climbing because of the threat of an impending supply shock. With Russia and Saudi Arabia already tightening their taps, global oil importers can’t afford to see Iran’s supply capabilities affected too. But forecasting the extent to which oil supply might be disrupted by the conflict and, more significantly, how badly individual companies will be impacted by those supply shocks is a tricky business. Oil analysts are notoriously bad at it: in 2011 an international discussion paper suggested that futures prices are “inferior to tossing a coin” in their ability to predict the actual future price of oil.

Don’t panic

And so, this all means that the investors need not fret over $100 a barrel - there is very little evidence to suggest a causal link between these rising prices and poor returns. And yet, I have just contributed to the armies of journalists, analysts and market watchers who are commenting on the oil price. Why? Because it does matter to investors. Because no matter what the literature says and no matter what our understanding of a situation is, we cannot collectively overcome our inherent, deeply human fears and reactions.

Thus, as ever, the important thing to do is stick to your strategy. Don’t let the external market dynamics which fall outside of your control make you waver from your process, no matter how many articles like this one you may be tempted to read.