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Commodity prices have surged over the last 12 months as the US economy reopens in an uneven manner putting pressure on supply chains. The S&P GSCI broad commodity index is up more than 60% over the last year and crude oil prices have doubled. Conventional wisdom suggests that rising commodity prices implies increased demand from an economy that is accelerating; and an accelerating economy should be good for corporate earnings and stock prices. However, a historical analysis of crude oil prices and subsequent changes in the S&P 500 suggests it’s possible to have too much of a good thing.
Oil Prices Depend on Economic Cycles
The price of oil is extremely cyclical. When the economy experiences a slowdown, like we did last year during the COVID-19 lockdowns, demand for oil declines and stockpiles grow. This imbalance between supply and demand caused oil prices to decline. In response to falling prices, energy companies cut oil production because it is less profitable at lower prices.
When the economy begins to recover, as we have witnessed over the last 12 months, oil demand increases causing stockpiles to dwindle. This creates the opposite imbalance between supply and demand, causing oil prices to rise. Rising prices make it more profitable for oil producers to pump more oil, so they increase production. As producers race to pump oil to increase their earnings, or the economy begins to slow once again, the cycle repeats.
There’s an old saying, “The cure for high commodity prices is, high commodity prices.”
What an Increase in Demand for Oil Can Reveal About the Economy
Rising oil prices are typically associated with rising stock prices. Increased demand for oil suggests economic growth is accelerating, creating more opportunity for businesses to grow. The last 12 months have certainly been great for stock investors as the S&P 500 has rallied more than 30%.
However, there is an argument for why rising oil prices can have a negative effect of future economic growth. Rising oil prices have a direct correlation with gas prices. As gas prices rise consumers are forced to divert some of their discretionary spending to increased prices at the pump. While the impact on any one person is relatively small, when you multiply it by 330 million Americans, it can really add up.
Short Term vs. Long Term Oil Price Gains
Financial markets are dynamic and constantly pricing in new information. As investors, we are forced to look to the future to determine the likely outcome for markets so we can better position portfolios. The table below looks at various changes in oil prices over the last 12 months and compares it to the subsequent return for the S&P 500.
Over the short-term, strong oil price gains, like the 100% gain we have seen, have historically resulted in rising stock prices over the next 1 to 3 months. However, when we look at longer time periods, say over the subsequent 12 months, the average return for the S&P 500 has been negative. This suggests that rising oil prices are good for stock investors. However, when we see oil prices double, investors should prepare for a more challenging environment in six to twelve months.
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