Higher stock prices may depend on rising oil

SATURDAY, FEBRUARY 24, 2007

If you want stock markets to keep rallying, then root for higher oil prices. That may sound like the counterintuitive advice of the decade. After all, traditional economic theory holds that costlier petroleum usually spells bad news for stocks. Companies’ production costs rise, reducing profit margins. And as more spending is diverted to gassing up the family car or heating homes, consumers’ disposable income shrinks. That translates into lower sales and earnings for many companies unlucky enough to be outside the oil or gas business.

True enough. Yet the massive amounts of liquidity that have propelled the prices of global stocks, real estate and contemporary art to stratospheric heights in the past four years may be altering the assumption that expensive oil is always bad for financial assets. From a low of $25.24 on April 29, 2003, the price of a barrel of West Texas Intermediate crude traded on the New York Mercantile Exchange has more than doubled to about $60 as of Feb. 22. During the same period, the Standard & Poor’s 500 Index rose 59 percent, the Dow Jones Stoxx 600 Index in Europe rallied 94%, the MSCI Emerging Markets Index more than tripled in value, and the Tokyo Stock Price Index has gained 131%.

As the price of oil skyrockets, petroleum-exporting nations become wealthier. In economist-speak, their current-account surpluses expand. Those petrodollar surpluses are then recycled to other markets, particularly the US, where the flows help finance the current-account deficit, which was $656 billion through the first three quarters of 2006.

Figuring out just where oil exporters stash their cash is one of the riddles of global finance. That’s because many allocate funds to institutions such as the Kuwait Investment Authority and external money managers, unlike Asian central banks, which tend to manage their reserves in-house. Still, the Federal Reserve Bank of New York in December estimated that $314 billion, or about a quarter of fuel-exporters’ combined $1.3 trillion in current-account surpluses from 2003 through 2006, was recycled back to the US directly. An additional chunk was probably recycled indirectly into dollars via third parties. “Purchases of US securities may be booked largely through intermediaries based in London or offshore financial centres,” the International Monetary Fund said in a report last April. The IMF estimates that about 60% of fuel exporters’ official reserves are held in dollar assets. What’s more, fuel exporters are becoming more important in the recycling business. At $528 billion, their current-account surpluses in 2006 surpassed Asia’s $437 billion for the first time since the 1970s. The flip side of higher oil prices leading to rising stock markets is that declining oil prices may lead to falling equities. That’s because cheaper oil translates into smaller current-account surpluses in places such as Saudi Arabia, Russia and Kuwait. That means less money to invest in the US and other financial markets. “There will be lower capital surpluses recycled back into major financial markets, particularly into dollar assets,” says Daniel Casali, an economist at London-based consulting firm Independent Strategy. “That will lower demand for equities and bonds and increase the cost of capital, particularly in the US, the main beneficiary of global capital recycling.”

There are, of course, caveats to the view that oil markets dictate equity prices. Much depends on why oil prices decline, says George Magnus, a London-based economic adviser to UBS AG. “If they fell because of supply increases and a global soft landing, I suspect the effects on markets would be benign.”

For fuel exporters’ current-account surpluses just to match last year’s total, oil this year would have to average about $70 a barrel, compared with a 2006 average of $66.23, Casali says. At $60 a barrel, oil is now 22% below its $77.03 record high on July 14, 2006. Oil this year will cost $60.50 a barrel, according to the median forecast of 36 analysts in a Bloomberg survey. Casali predicts an even lower $55. At that price, the exporters’ surpluses will fall by $152 billion to $376 billion, he calculates. After adjusting for an IMF forecast of a small increase in Asian surpluses, he says that capital flows may shrink by $139 billion. For a taste of what a pullback in global liquidity might be like, one could consider Japan’s decision last year to tighten monetary policy. From late March to mid-June, the country’s central bank withdrew $186 billion from domestic lenders, and Japanese investors responded by cutting their overseas holdings. From May 9 to June 13, the MSCI World Index fell 12%, while the MSCI Emerging Markets Index plunged 25%. Moreover, a 2004 study by the US Federal Reserve found that 10-year treasury yields fell 7 basis points for each annual $10 billion increase in net foreign investment in the US. That implies higher yields, if global capital flows shrink. And if cheaper oil ignites inflation, central banks may respond by raising interest rates, further hurting stock and bond markets.

The combination of lower oil prices and rising interest rates may be especially bad for energy and financial companies, which have benefited the most from higher oil prices and low interest rates, accounting for the lion’s share of global profit growth in 2006. Those two industries make up 35 percent of the value of the MSCI World Index, compared with 20 percent in 2000.

“Should the oil price fall further or even just stay where it is, global financial markets will lose a valuable source of liquidity and a major portion of corporate earnings could take a hit,” Casali says. So if you want stock markets to keep climbing, start cheering for the Arabs, Iranians, Russians and Nigerians, not to mention the Norwegians and Venezuelans. Otherwise, run for cover.[From Internet]