How Oil Pricing Affects Investor Decisions

Includes: DBO, OIL, USO
by: Chad J. Lapa

There is no doubt that the US places a heavy emphasis on the oil markets, both domestically and internationally, as both citizens and industry are heavily dependent upon its production and pricing to meet daily consumption needs. With oil prices hitting an all time high in 2008, economic speculation has been generated both supporting the continued price movement and suggesting that there will be a market correction within the year. Both positions are based upon recent current events and traditional investor behavior. To understand the pricing of oil and how it affects investor decisions, there are several important economic events and factors to become familiar with.

The early part of 2008 has proven to be a turbulent investment market for oil both in the United States and internationally. We have experienced prices hitting all time highs as well as slight (short lived) corrections based on news released related to the markets via government reports, only to see the oil soar to record highs again and again.

In early March, oil prices fell following a mixed report from the Energy Department’s Energy Information Administrating regarding the levels of oil inventory. The department’s analysts were looking for a decline in oil distillate supplies, but the reports showed a substantially greater decline than expected. On a positive note, the energy department’s report showed an inventory rise in oil barrels, causing an overall mixed review for the release of their information among the investor community. This outlook created a short term drop in oil prices, but the market soon rallied with another spike, causing oil prices to reach over $100 for the 2nd time in 2008.

With oil prices hovering around and above all time highs, consumers have been experiencing price increases in their every day consumables, putting even more pressure on the middle class and the average investor within the US. As gasoline prices increase, a consumer’s available discretionary income to spend in other market sectors decreases, putting pressure on the retail markets and other consumer driven economies. Decreased consumer spending can also occur with relationship to the oil sector; consumers who are unable to afford gasoline prices may turn to alternative methods of transportation that, in large enough volumes, can put pressure on the oil demand within the US. Both consumer reactions will affect the pricing of domestic oil.

In addition to pressure on retail spending, the uncertainty among investors as it relates to the US stock market has a direct effect on the oil market. Investors have been traditionally known to turn to commodities as an investment alternative when the stock market becomes volatile, as commodities have less correlation to the same economic indicators as traditional stocks or bonds.

Another significant correlation to understand with regards to the US oil market relates to the value of the nation’s currency. When the US dollar becomes weakened, the oil market responds favorably. When the US dollar falls, it provides less financial incentive for foreign countries to increase oil outputs which reduces oil supply. This reduction in supply is known to cause a rise in oil prices. Crude oil in particular is thought of as a hedge against a weakening dollar by both domestic and international investors. As the US dollar has been on a steady decline in recent months, there has been a surge in investor interest within the oil markets, also contributing to the rise in price.

Another economic factor to become familiar with is the relationship of US interest rates and oil pricing. With the Fed completing a series of interest rate cuts already this year in an attempt to stimulate the US economy in hopes to avoid a recession, the oil markets experience stimulation as this is considered among international investors to be a sign that the US economy is declining.

All of these factors have positive and negative correlations to both domestic and international oil pricing and are important to understand if you are personally considering taking a position in this always interesting market sector.