Four theories on how oil has hurt markets

Even casual observers know that oil is exerting an uncommon influence on stocks. What is less clear is how the energy market has come to dominate sentiment in industries with seemingly no connection to crude prices.

Understanding why oil is casting such a spell is more than an academic inquiry.

The reason matters, given how big the moves have been.

Almost $1.6trn (€1.47trn) has been erased from US stocks alone in 2016. If oil is contributing, it would be nice to know why.

Here are four theories on what’s underpinning the connection.

1) The Economy Theory: Oil traders have sussed out information on the direction of the global economy and the plunging price reflects a world hurtling into a recession.

US stocks have taken note, or have drawn the same conclusion on their own.

“Oil is a proxy for global demand and growth and there’s a real view as prices move it’s reflective of the global economy,” says Michael Arone, the Boston-based chief investment strategist at State Street Global Advisors’ US Intermediary Business.

2) The Credit Theory: The price of crude underpins the value of so many corporate bonds and loans that its 57% decline since June will ignite a crush of defaults that bankrupt hedge funds and banks. Energy makes up a fair portion of riskier bonds.

“The major risk banks have is not to their normal retail oriented stuff, it’s to the oil space,” says Andrew Brenner at at National Alliance Capital Markets.

Default rates in the oil patch could reach as much as 15% this year, with the overall corporate default rate rising to 7%, according to BCA Research.

Furthermore, energy companies are on the hook for $190bn, or 2% of all bank loans.

3) The Investment Theory: Energy and commodity companies do so much hiring and building in the US economy and when they stop, earnings will suffer both within and outside of the industry.

“The energy space was the fastest growing part of the US economy post-financial crisis and now it reverses. Businesses are shuttered and people are laid off,” says Nick Sargen at Investment Advisors.

“There are some people beginning to worry this thing could spread like the subprime crisis.

"People had said then that it was too small to matter, and then you find out there are linkages you didn’t know about.”

4) The Pain Trade Theory: The world’s biggest investors are being forced to sell everything that is not nailed down to offset the hit they are taking on their crude holdings.

After getting pummelled in commodity trading, investors may be stepping into stocks and unloading.

After years of using oil money to buy assets, now they’re selling them, sending petrodollars pouring out of investment vehicles such as sovereign-wealth funds.