What Do High Energy Prices Mean for Equities?

A new week has dawned with markets looking a touch rickety. This has frankly come as a bit of a surprise to Macro Man after Friday's by-now de rigeur late-session squeeze in the SPX, as well as broadly supportive policymaker comments over the weekend. The G8 is not quite ready to take away the punchbowl, it seems, and the BRICS have (in public, at least) pulled back from seeming to want to create a dollar crisis. And for today at least, the usual suspects have been absent from the FX market.

Perhaps the most amusing comment from the weekend came from German FinMin peer Steinbrueck, who warned of further credit dislocations in Europe, putting his marker down to cover his ass in case it all goes wrong. Evidently, winning "European Plonker of The Year 2008" for his powerful mix of forecasting ineptitude and hubristic scahdenfreude deeply affected him, as it seems he wants to avoid a repeat victory.

Regardless, markets are trading on the back foot to start expiration week. There are a number of indices that seem to have stopped in their tracks over the past month or so, remaining broadly supported but unable to breach recent topside highs. Momentum has clearly ebbed and, technically at least, the set-up for shorts looks reasonably attractive. The SPX and Eurostoxx are currently supported by their 200 day moving averages in close proximity, but something like the FTSE Midcap 250 has a lot of room to fall before entering the neighbourhood of the 200d MA.

Click to enlarge

One issue that has been gnawing at Macro Man has been the seemingly bullet-proof performance of equities over the past three months despite a very real hit to global disposable incomes and operating margins thanks to the sharp rise in energy prices.

Now to a degree, the positive correlation between energy and equities can be seen as a function of either reflation or short-covering. Macro Man hasn't got much of a beef with that interpretation.

However, the strength of the relationship has really puzzled him, as it's felt like oil and equities have been the same trade since March. Even if it is the energy sector that has led the rally (and really, it's been the financial sector), the same thing held true last year.

And yet the correlation between daily equity returns and returns on crude oil (as proxied by the second WTI future) has never been higher, at least since Bloomberg's crude futures data starts in 1986.

Click to enlarge
Now, Macro Man would be willing to bet that this high level of correlation is not sustainable. The hit to disposable incomes from high and rising energy prices is like an industrial-strength dose of Roundup poured on the global economy's green shoots.

How to play this relationship directly is another matter. His discreet enquiries about exotica like SPX/CLZ9 correlation swaps met with zero interest from his panel of counterparty banks. Frankly, it would probably meet with zero interest from his risk manager as well.

Playing the markets individually in a linked strategy introduces an element of conditional directionality that undermines the 'purity' of the trade. So for the time being, Macro Man is watching... and waiting. At some point, the penny from high energy prices may well drop into the equity market space. Macro Man intends to be there to pick it up.

Comments

[Ferdinand E. Banks]

Maybe I'll write another energy economics textbook that features the information in this article. Of course, just because I wright it doesn't mean that I will read it, or recommend it to my students because - as the author notes - those correclations mean that something is drastically wrong somewhere.

2009 Jun 15 10:08 AM

[Mad Hedge Fund Trader]

How about down? I heard a little tidbit yesterday that makes me feel like I just ate a bad fish taco. Frontline, the world’s largest tanker company, says that it has 100 million barrels in storage, the equivalent of five days of US consumption, the result of the spectacular contango situation that exists in the crude futures market. Traders have been buying front month crude, storing it, and reselling it one year out for non leveraged profits of up to 75%. With spot now at $72.12, and futures for December delivery selling at $75.56, that spread has narrowed to an annualized 9.53%. The last crude top was made by the filling of the Strategic Petroleum Reserve. Could this intermediate top be put in by the filling of the world’s excess tanker fleet? This makes me worried not just about crude, but all of my longs in commodities and their producing stocks, the S&P 500, the BRICK’s, and everything else that has enjoyed a torrid doubling since the beginning of the year. Could gold’s poor performance this week, which dropped from $990 to $935, be the canary in the coal mine? And by extension, is it time to take profits on my short Treasury positions by selling the TBT, which has also doubled? There are just too many charts hanging around their 200 day moving averages to dismiss this lightly. I hate to sound redundant, but selling in May is looking more clever by the minute. Cash is King.

2009 Jun 15 10:37 AM

[iggyDalrymple]

"What Do High Energy Prices Mean for Equities?"

My research shows that companies that are net producers of energy will benefit from higher energy prices......as opposed to net users of energy.

2009 Jun 15 12:19 PM

[odin]

All part of the green shoots. The lower the quality of earnings, the higher the pop in this recent rally. Financials traded like options -- I am not too surprised. However, given the wide contango in oil, should a high-risk, capital intensive, environmentally sensitive business, it does appear that the beta of energy stocks actually moderated.

I, too, expect the beta of energy stocks to pick up. Whether or not the green shoots wither.

And speaking directionally, if the inflation story does not pan out and given that storage costs inevitably are rising/will rise in the positive carry trade environment (esp. as additional storage becomes harder and harder to find), spot oil will find the landing very hard indeed. Energy companies, esp. those with leverage, will not find the environment to their liking. May be some sort of a energy/industrials pair trade?

2009 Jun 15 04:30 PM

[anarchist]

You find this idea in a fortune cookie?


On Jun 15 07:37 PM cheap oil now wrote:

> OIl need to be at $10 barrel. I'm tired of funding terrorists with
> petro dollars.
>
> When folks finally see that they can’t just get someone else to pay
> for all this, there will likely be a huge tax rebellion which will
> cause more short term problems, but may in the long term (hopefully)
> have the effect of getting the government to manage our money better.
>
>
> good econ articles: short.ie/g264dk

2009 Jun 15 07:42 PM

[CLH]

High energy and commodity prices make little sense. They will soon head back down probably destroying the rally. Gold also will head back down---there is little reason for inflation in a credit crisis.

Im shorting commodities but holding other equities.

2009 Jun 16 07:43 AM