How oil prices are affecting the stock market

What's the deal with rising oil prices and does it affect the stock markets?

In the last few weeks, the papers have been all about oil prices. Crude oil prices are skyrocketing and recently the shortage was such that reserve barrels had to be released. If they are so important, how are they affecting the economy? And stock markets, to be precise? Before telling how they do, let's understand the importance of oil in a country like India.

Importance of oil

According to data collected over the years, India is the 10th largest importer of oil in the world and ranks among the largest oil-consuming countries. About 30% of India's total energy consumption is met by oil. The dependency is perpetually rising and stood at 77% of domestic needs till January 2021. It represented 21.6% of the total imports. To give you an idea of how much oil is got here relative to other countries from Saudi, here is a graph from the OPEC website:

(in million barrels)

Oil is a major input for products like paints. Moreover, it is most needed by transport and logistic companies, that form supply chains of so many other industries today.

Oil, around the world, is mainly procured from the Middle East, precisely major amounts coming from Saudi Arabia, Iraq, UAE, and Kuwait. Here is where India gets its crude oil from:

The oil supply chain

A huge part of the economy is affected by oil and oil prices dictate major input costs for many companies. For every job created in oil production, 3 jobs are created in the supply chain and 6 more in the broader economy.

Since a majority of oil is located in the middle east, prices, especially for a major importer like India are susceptible to oil shocks and supply disruptions in the Arabian Gulf. Crude oil prices are bound to soar each time there is some crisis there.

Whenever there is a problem in those countries and the economy is in trouble, oil is the only rescue operation they have. Given the OPEC domination, prices soar whenever they need money. This is during the First Gulf War, the 2008 Oil Shock, and the recent price war between Russia and Saudi Arabia. It's evident even currently. They aren't willing to curb prices even after some countries- India, the US, China, and Japan have collectively pleaded for them to do so.

For some time in 2020, oil prices had gone down to $19 per barrel. But instead of reducing the price, the Indian government increased its taxes (and State governments too). They did this to build reserves. But now that global prices are soaring, they refused to cut taxes, and the price we pay as consumers are skyrocketing. Here is how the cost we pay typically looks like:

Source: Finshots

How does it affect markets?

Here are the sectors most affected by oil prices:

Exchange Rates:

India imports more than three-fourths of its oil needs. A rise in oil prices will enlarge our current account deficit situation. We are spending more for the same value and the rupee will depreciate, which makes the imports costlier. This will affect the companies who depend on imported crude oil and other raw materials, for their business. For example, energy and paint companies. The price of such stocks is likely to experience a fall. The fall of oil prices will trigger the inverse.

Input Costs

Companies making tires, lubricants, airplanes, etc. regard crude oil as a major factor of their input costs. When prices rise, their costs shoot up, even if they are advantageous at economies of scale. It negatively impacts productivity and one can witness a decline in their stock prices in the quarter following the oil price rise. However, when oil prices fall, a company sells their goods or services with not much reduction in their selling price, to make up for the lost profits.

Transport:

Consumer goods are affected by crude oil prices considerably. Manufactured anywhere, goods are transported to different cities across India, and the cost of logistics is affected by fuel prices extensively. When prices rise, selling prices of goods rise too, contracting demand and negatively affecting their stock prices. This is also perceived as inflation and is well known to further affect investor sentiments.

Effects aren't that drastic though

However, some studies suggest a negligible correlation between oil prices and the markets. Researchers at the Federal Reserve - Bank of Cleveland prove so in one of their reports.

As named above, there are only a few sectors affected by stock markets dramatically than others. And as the transportation industry is going through a revolution because of electric vehicles and more companies adopting a work from home policy, the dependence is reducing.

Moreover, modern financial instruments like forwards and futures contracts help companies sensitive to oil prices hedge their positions and prevent unforeseen losses.

Investor's Perspective - Conclusion

Crude oil is required by some industries directly but certainly affects all others indirectly. Happenings in the OPEC are responsible for drastic changes in prices demanding investors to have an eye for the same. Being aware can help exploit opportunities presented by movements in stocks of sectors affected by oil. Also, one can gauge inflation and its related effects on the markets by being aware of the global oil situation.