First, though, not that these are only hopes; futures markets are pricing in Brent crude returning to $80pb by 2017. Nevertheless, simple statistics tell us there is a fair chance of a big fall. The standard deviation of annual changes in Brent crude since 1988 has been 35 percentage points, implying that there is around a one-in-six chance of it falling below $50pb by this time next year.
You might think this is a lovely prospect. A lower oil price is in effect a tax cut for oil consumers, which should lead to lower inflation and higher output.
In this context, then, here's a surprise. The correlation between annual changes in Brent crude and in the All-Share Index has been positive: 0.13 since 1988 and 0.37 since 2000. This implies that a lower oil price is, more often than not, accompanied by falling share prices.
There's a simple reason for this. Whether a fall in oil is good or bad for equities depends upon why it falls. If it does so because of a slowdown in the global economy, shares would fall. If, however, it does so because of extra supply, its effects would indeed be more benign. Historically, falls in global demand have been, on balance, the bigger cause of falls in oil prices - hence the positive correlation.
We can get another take upon this question by looking at sectors' correlations with oil, controlling for moves in the All-Share Index. Doing so shows that there are winners and losers from a falling oil price.
| ||||||||||||||||||||||||
The biggest losers might surprise you. One is mining. This could be because it is unusually sensitive to the swings in world demand that cause moves in oil prices. Or it could be because many commodities are correlated with oil.
A second loser is the IT sector. Tech stocks, remember, boomed in the late 1990s when the oil price shot up. This might not be a coincidence. A fall in oil would make what we used to call the 'old economy' more viable and so would retard the process of creative destruction in favour of what we used to call the 'weightless economy'. That would hurt tech stocks.
On the other hand, many sectors do indeed gain from falling oil prices, as you might expect. These gains, though, while statistically significant, aren't huge. They are mostly around one percentage point for each 10 per cent drop in oil. This implies that a one standard deviation drop in oil would add around four percentage points to annual returns. That's decent, but not huge.
There's a reason for this. Because oil prices are so volatile, their price moves contain a lot of noise and little signal. And we tend to ignore things that are noisy - hence the small effect.
This isn't necessarily disappointing, It's not at all certain that oil will continue to fall. James Hamilton of the University of California San Diego says that a lot of the recent increased supply comes from high-cost producers who aren't profitable at sub-$70pb prices. As they cut output, he says, prices could recover. Futures markets agree with him. My table might, therefore, have a different use; it shows us the losers from rising prices, too.
Perhaps the main message from this is that we should not change our equity strategy on the basis of hopes that oil does continue to fall.
