Oil prices are dropping

US stock investors are cautious that a 30% drop in oil prices will put pressure on corporate profits while showing signs of weakness in global growth at a time when it is already weighing when the long economic expansion will end.

Crude prices rebounded off of one-year lows for the beginning of the week, with investors focusing on the meeting of the OPEC in Vienna on Tuesday and allied producing countries including Russia. A monitoring committee of OPEC and its allies have agreed on the need to reduce oil production in 2019, two sources familiar with the discussions said.

Oil’s fall holds economic benefits, including lower costs for some companies and cheaper fuel prices for consumers. Investors, however, are already bracing for a significant decline in US profit growth next year, and the drop in oil prices is poised to bite into profits for energy producers and related companies that are part of  Wall Street’s benchmark S&P 500 stock index .SPX.

OPEC and allied producers used production cuts to curb an oil glut, which led the prices from 2014 to a prolonged decline bringing prices to below $30 a barrel in early 2016. But supplies again grow, and the US trade war – other factors have investors concerned that slowing economic growth can erase demand and send prices down.

“What started the sell-off on oil was a supply issue,” said Alicia Levine, chief market strategist at BNY Mellon Investment Management. “In the last couple of weeks, what we are getting is fears of slowing demand. And fears of slowing demand are directly related to fears of global growth slowdown.”

Crude oil prices have dropped by 30% or more than 13 times since 1982, according to Ed Clissold, chief US strategist at Ned Davis Research. From the previous 12 events, the oil fall has overlapped eight times with what Ned Davis Research defines as a cyclical bear market – a 30% fall in Dow Jones Industrial Average .DJI after 50 calendar days or a 13% drop after 145 calendar days.

However, finds Clissold, in only three of those cases did the oil decline overlap with a U.S. economic recession.

Futures contracts for U.S. crude CLc1, known as West Texas Intermediate (WTI), topped $75 a barrel at the beginning of October. The commodity slid to as low as $49.41 resent week, but has clawed back since and is now trading nearly $53. Brent LCOc1, the global crude benchmark, has notched a similar percentage decline.

“Somewhere in the $50-60 level, it’s probably a good level for the market, because producers are making enough money and it’s also helping the consumer,” said Keith Lerner, chief market strategist at SunTrust Advisory Services in Atlanta. “But if you see an abrupt move down, the bigger concern is what is that signaling about the global economy.”

The oil drop coincided with an increase in the turbulence of the stock market. The benchmark S&P 500 .SPX late last month confirmed a correction, a drop of more than 10% of its high values. Still, investment optimism for the less aggressive way of US interest rate hikes prompted a modest market rebound.

Both oil and equities markets have been focused on international trade, China’s economic health and the global economy, said David Katz, chief investment officer at Matrix Asset Advisors in New York.

“For the near term, the two are very closely correlated,” Katz said.

From the oil peaks in October, the S&P 500 energy sector dropped 16%, nearly two times lower than the overall S&P 500. Analysts have been lowering earnings estimates for the sector, with S&P 500 energy companies expecting to increase earnings by 21.3% in 2019, compared with expectations of 26.2% on Oct. 1, according to IBES data from Refinitiv.

Many investors see positive results in the oil downturn, including the potential stimulation for consumer spending through lower gasoline prices. Lower fuel prices may help to check inflation, which will allow the Federal Reserve to slow its program of US interest rate hikes.

But David Bianco, Americas chief investment officer for DWS, estimates that every $5 per barrel drop in oil prices shaves $1 to $1.50 per share from S&P 500 earnings. The S&P 500 is expected to earn $162.81 per share this year, according to IBES data from Refinitiv.

This earnings impact involves not only energy companies but also industrial producers who serve the energy sector. It also accounts for any earnings boost for companies like airlines and consumer companies that benefit from lower fuel prices.

“The S&P is much more of a commodity producer than a commodity user,” Bianco said. “Higher commodity prices bring higher profits and lower commodity prices bring lower profits…This is one of the most reliable relationships when it comes to corporate profitability of them all.”


Source: Reuters