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NEWS ANALYSIS: Financial fears form correlation between oil and equities

Liquidation, profit taking in energy markets offset losses in equities

(LONDON) Oil and other commodities typically lag more mainstream assets, making them attractive as investment portfolio diversifiers, but since January, they have been swept up in the volatility gripping nervous equity markets.

The correlation between US crude and US equities has been 82 per cent, compared with 37 per cent the previous year and -63 per cent in 2006, according to figures from Standard Life covering the start of the year to last week.

For North Sea Brent crude and British equities, the link has been even tighter at 88 per cent, compared with 7 per cent last year and -37 per cent in 2006.

The new-found – and probably short-lived – closeness can be explained at least in part by liquidation and profittaking in energy markets to help to offset losses in equities and other assets that have headed lower in response to fears of recession.

‘At times oil and equities can briefly track each other for a variety of reasons . . . but there is nothing stable in that relationship,’ said Antoine Halff of Newedge brokerage.

The economic worries that have driven selling on stock markets are also bearish for oil markets as an economic slowdown would reduce demand, but traditionally oil markets react at a different pace from equities.

‘Equities discount growth fluctuations upfront. Commodities do it when it actually happens . . . Equities will fall first going into recession and recover first,’ said Tim Bond of Barclays Capital.

Negative correlation, or commodities and equities behaving differently, is useful for long-term investors, who want balanced portfolios.

But for some speculators on the oil markets, the stock market sell-off has provided much-needed direction.

‘The oil market has been in a relatively quiet period with no major winter threats, no major supply disruptions, and the higher volatility in equities has become a directional input for oil markets that were lacking a clear driver,’ said Olivier Jakob of Petromatrix.

He traced the link between oil and equities back to Jan 17, when the Dow Jones Industrial Average broke a major support line and he too predicted that the correlation would be temporary.

Technical traders can run an algorithmic model that trades oil according to equity indexes when the correlation becomes high.

‘This will work as long as the two markets trade on the same fear factor, but will break down as soon as the core fundamentals start to price back in,’ Mr Jakob said.

Fundamentals of supply and demand for oil and other commodities remain strong and are likely to do so for as long as economic growth fears are focused on the United States and Europe.

These regions have accounted for a small proportion of incremental demand compared with the expanding Chinese market.

‘Chinese growth estimates have slipped a couple of points,’ said Mr Bond.

‘If they slip another couple of percentage points, we’d have a more convincing case for commodities coming off.’

The growth of consumption in China and elsewhere in Asia has tightened supplies to the extent that commodities in general look more resilient than they have during previous economic slowdowns.

‘Commodity prices are more inelastic to changes in growth than they were in the past,’ said Mr Bond.

Over time, they were still expected to perform the task of diversifying a portfolio, although in the event of ‘a severe downturn’, they would be expected to fall in line with general market weakness.

Fundamentals for oil can always be strengthened by producer group the Organisation of Petroleum Exporting Countries (Opec), which can cut supply in an effort to support prices.

‘Opec – specifically Saudi Arabia – has a record of acting as swing producer, reining in flows when demand drops,’ said Mr Halff.

He added, however, that Opec’s ability to manage supplies should not be overstated and the lengthy amounts of time needed to bring on new supplies is one of the reasons oil markets tend to lag other asset classes.

‘While the demand side of the oil market may broadly track the underlying economic cycle, the supply side doesn’t do so as closely because of the long lead time of oil development projects,’ said Mr Halff.

Oil prices can set the pace, as well as follow. A major oil supply shock, for instance, would have knock-on effects for equity markets, which include significant numbers of resource-holding companies sensitive to commodity price movements.

‘UK equities have a large oil component in them – 17.4 per cent – plus mining – 9.5 per cent – meaning that more than a quarter of the equity market is commodity price sensitive,’ said Richard Batty of Standard Life.

 

Source: Reuters (Business Times 11 Feb 08)

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