Editors' pick: Originally published Jan. 28.
The full impact that oil will have on the stock market this year is currently unknown. There is no historic evidence that suggests that the price of oil alone has more than a limited effect on the stock market. There is some correlation between the two recently; but, correlation does not equal causation.
But when it comes to knowing when oil hits bottom, investors should focus on those who supply the black substance rather than who depends on it.
The Cause of the Slump
Oil prices are based on supply and demand. The greater the demand, the higher the price. An over-supply can affect prices negatively. This over-supply is what is happening in the market right now. Right now, American, Russian and Middle Eastern oil companies refuse to slow production despite tumbling oil prices. At the same time, the Chinese economic slowdown means that the demand for oil is also dropping dramatically.
The two actions happening simultaneously is the catalyst behind the prices hitting 12 year lows.
Current Market Projections
Oil prices have dropped around 20% in the last year. As the price per barrel continues to fall, investors have cautiously waited for oil to find the floor. Although a rebound last Thursday was not a surprise, the markets have not yet seen the lowest prices.
Investors will need to pay close attention while waiting for the lowest oil prices. Some analysts suggest that the floor on oil will be a whimper rather than event. It is also predicted that the low for oil prices could be $20 a barrel. However, investors are advised not to wait for the $10 prices. This price would fall dramatically below production costs. As a result, oil companies would be negligent to supply it.
To find that bottom price, you need to look for a climb in demand and a fall in production. In particular, investors should search for low production from the U.S. and greater demand from China where the use of discount codes if fueling consumer demand. Both of these things could happen soon as American oil companies feel the pinch and Beijing readjusts its economic outlook.
However, this needs to be a long-term change to pull oil back towards equilibrium and create more stability in energy shares.
The Iranian Factor
The lift of sanctions on Iran is going to continue to play with oil prices in a big way. Iran has the potential to be a major global supplier now that it can sell its oil on the market.
Unfortunately for Iran, oil is already over-supplied. This means that the entry of new oil is likely to drive prices even further down. This is a problem for oil prices and for the geopolitics of the region. Saudi Arabia has no intention of producing less than its standard 10 million barrels a day. It does not care what Iran's entry to the market means. Unfortunately, Iraq is also nearing its limit for daily production. Iraq is cash poor and relies on oil production to stay afloat. Giving up oil in favor of higher prices is non-negotiable for Iraq right now.
The best thing for oil prices is would be for these three countries to work together to manage their outputs.
Unfortunately, the geopolitics of the region suggests that this is not likely. A hit in oil output would mean admitting defeat in the eyes of a political adversary.
What This Means for Investors
There is going to be a continuing weakness in energy shares as oil prices continue to drop. As energy companies continue to produce more oil than necessary, oil prices will plummet and energy stocks will follow.
However, this provides an opportunity for savvy investors. To make the most of energy shares and stock market holdings, investors should keep an eye out for the Americans to relent on oil production. This will a clearer signal the oil prices have hit the floor. It will be a good point of departure for anyone interested in the rebound of prices, which could hit $60 a barrel next year.
The price of oil is also going to nail emerging economies that depend on commodities. If there is trouble this year, this is where it will begin. The emerging markets have a big role to play on the American stock market. As oil prices continue slide, these economies will take the worst hits. The ramifications of the collapse of these markets is what will hurt your investments the most.
In short, do not worry so much about the price of oil. Instead, investors should keep their eyes on those who depend on it.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.