What’s Wrong With Bernanke’s ‘Relationship Between Stocks And Oil Prices’

Ben S. Bernanke. Official portrait.

The financial press has been commenting on recent correlation of stock prices to oil prices. A recent Wall Street Journal article put it: “Oil and stock markets have moved in lockstep this year, a rare coupling that highlights fears about global economic growth.”

Ben Bernanke published an article Friday on his blog at Brookings, “The relationship between stocks and oil prices.” He began by stating we should expect a negative relationship between stocks and oil prices because decreasing oil prices are a benefit to the U.S. economy and vice-versa.

But, in fact, there has been a positive empirical relationship between stocks and oil prices. He provides 5 ½ years of data that show the correlation is positive, on average, with a correlation of 39%.

He concludes that there are two reasons for the positive relationship.

“Much of this positive correlation can be explained by the tendency of stocks and oil prices to react in the same direction to common factors, including changes in aggregate demand and in overall uncertainty and risk aversion.”

Weakening global demand will cause stocks and oil prices to drop. He concludes that his “demand equation” indicates that oil prices would have fallen by 40-45% as a result of demand, having nothing to do with oversupply.

Counterarguments

Oil is hardly a proxy of the U.S. economy. In fact, energy makes up less than 3% of the U.S. economy, according to the Bureau of Economic Analysis.

The relationship between stock prices and oil prices is not stable. It has been positive and negative, depending on what timeframe is selected. For example, although it has been positive 39% over the past 5 ½ years as Mr. Bernanke says, that is an arbitrary period. If the period from when oil prices peaked (June 20, 2014) is selected, the correlation is -41%. If the period from when SPY peaked is selected, the correlation is +52%.

Over the long run, it has been true that rising economic growth has created higher oil demand, which has provided support for oil prices. However, the nature of the relationship between economic growth and oil demand has changed greatly over time.

As Mr. Bernanke noted in his speech at Class Day at Harvard in 2008, “Since 1975, the energy required to produce a given amount of output in the United States has fallen by about half…This improvement in energy efficiency is one of the reasons why a given increase in crude oil prices does less damage to the U.S. economy today than it did in the 1970s.”

As I previously wrote, OECD oil consumption, which includes the U.S., European Union and Japan, peaked in 2005. In the European Union, peak oil consumption occurred in 1979. Oil consumption in Japan peaked 20 years ago in 1996. In the United States, peak consumption occurred in 2005.

Demand Equation

To assess oil prices, he used an equation with three independent variables: changes in copper prices, changes in the ten-year Treasury interest rate, and changes in the dollar. He argues that this equation “predicts” a drop in oil prices of 40-45% since June 2014.

The fact of the matter is that oil demand has been rising during this period, not falling due to poor economic conditions. Based on world consumption data from the Energy Information Administration (NYSEMKT:EIA), oil use rise by 1.5% in 2015 v. 2014 and is expected to rise again in 2016.

The demand equation includes the value of the dollar which has been rising. I have argued before that the dollar is a very minor factor in oil demand due to the high inelasticity of oil demand.

No Supply Variable

Finally, I argue that the reason oil prices have fallen is due to supply, which is ignored by this analysis. The breathtaking rise in U.S. shale oil production from 2012-2104 shifted the supply-demand balance. The Saudi overproduction beginning in late 2014 accelerated the price collapse.

Conclusions

I studied economics alongside Ben Benanke at Harvard. We were two of six econ majors in our tutorial. Despite that, I cannot agree with his analysis.

Last month, Goldman Sachs President and COO Gary Cohn said the oil price collapse is confusing investors in global equity markets. “Everyone’s relating the sell-off in oil to be an economic slowdown…I don’t believe the sell-off in oil is reflective of an economic slowdown,” he said. I agree with Mr. Cohn.

Equity prices may be highly related to oil prices right now because low oil prices have been hurting economies from some states in the U.S. like Texas and North Dakota, as well as oil producing countries from Canada, Russia, Brazil, Venezuela.

The potential for bankruptcies and loan defaults in the energy sector is a threat to the banking sector and is causing junk bond yields to spike.

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