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Why oil and stocks are trading in lockstep

Recently, every time the price of crude oil drops or rebounds, the stock market follows closely behind. On Wednesday, February WTI oil futures tumbled 6.7% to $26.55 per barrel, and the S&P 500 slumped 1.17%.

The next day, WTI oil rebounded to $29.53 per barrel, and the S&P 500 closed slightly up. In early trading on Friday, both oil and the S&P 500 marched higher in lockstep.

This close trading relationship is quite unusual—there has not been a strong positive correlation between oil and the S&P 500 in the past five years. In fact, as of last year, they were trading in opposite directions.

S&P 500 vs. Crude Oil Futures
S&P 500 vs. Crude Oil Futures

Research conducted by the Federal Reserve Bank of Cleveland in 2008 found no statistically significant relationship between S&P 500 and oil prices, meaning that oil and stock prices historically have moved independently of each other. According to Cumberland Advisors, citing Barclays data, the correlation between the S&P 500 and oil has been about 25% over the last 20 years.

Yet, since December 2015, the correlation is almost 90%.

S&P 500 vs. Crude Oil Futures
S&P 500 vs. Crude Oil Futures

We think of cheap oil as being good for the consumer, which in turn is beneficial for the economy. So what is causing this unusual tie-up?

Risk of default

Shale oil drilling is a capital-intensive business, and it takes a long time for these companies to adjust to price changes. Drillers must issue large amounts of debt and equity to raise funds for their operations years before they reap any profit. Given that the price of oil has plunged over 80% since mid-2014, concern has spread that the drillers may not repay their loans in full, exacerbating problems in the credit markets.

According to data compiled by Yahoo Finance, over 99% of 559 oil and gas companies are in a bear market. Furthermore, one-third of those companies have fallen over 90% from their highs, which is an indicator of potential bankruptcy issues.

This has implications for many banks that have exposure to these oil companies in the form of loans that may not get repaid. Wells Fargo's fourth-quarter report showed an additional $90 million in losses from its oil and gas portfolio, while Citigroup recently added $250 million to its reserves specifically for bad energy loans.

Going forward

This strong positive correlation between oil and the S&P 500 is likely to continue in the short term. If the price of crude rebounds, the stock market is also likely to rebound, as the credit contagion disappears.

But in the long run, don't expect this close partnership to last.