Blogs | November 23, 2016

Oil and gold: beware of price patterns when investing

Charles asks: I always thought cheap energy was a good thing – maybe not for energy suppliers, but for most of us. Then why were markets positively correlated with the oil price early in 2016? Was there a common factor behind it?

Ian answers: Charles, you ask what has been behind oil price patterns – perhaps sovereign wealth funds, monetary policy or worries about the global economy. Yes, many factors can affect prices, whether the price of oil or anything else.

Also, I agree with you, cheap energy can be a good thing – lowering the cost of doing business, and freeing up consumer budgets to spend more on other things. In general, when it comes to fuel prices, the macro people might say a reduction is just like having a tax cut.

Yet the market reality can be quite different. It really all depends on the specifics at the time. Because when oil prices fall, demand may also fall – and if this happens, it’s not really like a tax cut at all. Correlation is not causation.

Testing, testing
In finance and economics, we often guess at answers based on very few inputs. We often get very few chances to test something fully. And when we don’t have enough information, cognitive errors – such as relying on natural biases to divine the most “reasonable” answer to a question – are much more likely to occur.

A relationship or pattern we think we see may not really exist. It’s a quirk of the way our brains work that we tend to see patterns which are not really there and even assume they really mean something – think of faces in the clouds, for example.

This is one way that storytelling can harm to investments, because it can tempt us to assume a cause-and-effect relationship between two things when in fact there is no direct link: they are merely happening at the same time. Confirmation bias – the natural tendency to see what we expect to see – can further reinforce our beliefs.

So let’s look again at oil prices versus the market. Oil prices have been relatively low for the last couple of years, even though it has been getting harder and more expensive to drill for oil worldwide. We’re not oil market specialists: however, it’s clear that some experts consider OPEC played a key role by deciding to keep supply high. This was despite low prices, commentators say, in a bid to defend its market share (yet also potentially reducing demand).

Meanwhile, people, companies and even oil-producing countries – as Undercover Economist Tim Harford has pointed out – can respond to low prices, not by spending more but by saving more. This can obviously have a knock-on effect on share markets more broadly.

Not always positive
And if you look at historical oil price movements versus the markets, as explained in this Forbes article, there have been periods when there has been a positive correlation between the two, others when there has been a negative correlation, and still others when no connection was visible.

These are complex systems that are not stable. They change and adapt in response to multiple factors. If there’s any message in all that for the investor, it is to be careful of apparent patterns of cause and effect – and always do your research thoroughly.

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Ian Bright
Ian Bright

Senior economist at ING
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45 blogs

If you have a question for Ian, ask him here.