As price of oil soars, stock markets slump

Uncertainty over oil prices is a factor in Wall Street edginess.

Investors are finding out that oil and stocks don't mix.

As the price of oil has soared – oil hit a new record of $142.99 per barrel last Friday – markets have slumped.

With the price of petroleum up 50 percent since the new year, the Standard & Poor's 500 index is down 12.6 percent. In the past month, the S&P has dropped 8.7 percent, the largest June decline since 1930, when the Great Depression was just starting. At the same time, the price of oil is up $13 a barrel, or 10.2 percent, for the month.

"Basically, Wall Street does not like uncertainty," says Sam Stovall, chief investment strategist at S&P. "This is the first time it doesn't know something – how high the price of oil will go."

The turmoil on Wall Street and rising price of oil is coming at a time when there are renewed concerns about another sector of the economy: banking, which continues to see large write-offs from the subprime mortgage crisis. That could be helping to drive some investors from stocks into commodities, including oil, market analysts say. This, in turn, keeps the price of oil moving higher even as supply-and-demand fundamentals deteriorate.

Normally, a slide in stocks does not necessarily translate into problems on Main Street. Indeed, the economy is currently receiving some strength from consumer spending as a result of the US government's fiscal stimulus package. On Friday, the Commerce Department reported that consumer spending in May rose 0.8 percent on a nominal basis.

But newspapers are now reporting that the Dow Jones Industrial Average, a narrower measure of the stock market, is in an official bear market (a market on a downward trajectory). The Dow is down 20 percent from its peak of last October.

The prospect of a bear market could weigh on consumer and business psychology. Economists are concerned this could move the economy from a slowdown into a serious recession.

"We could be looking at a longer, deeper recession," says Fred Dickson, chief market strategist at D.A. Davidson in Lake Oswego, Ore. "Normally, the Federal Reserve would be able to step in, but after they met last Wednesday, a lot of people on Wall Street said, 'They are really hamstrung. There is not much they can do.' "

Last Wednesday, the Federal Reserve left short-term interest rates unchanged. The Fed toughened its language on inflation but did not send a clear sign it would be raising interest rates anytime soon. The Fed would normally raise interest rates to try to curtail inflation.

"What is missing now is the Fed rushing in," Mr. Dickson says. "Now, possibly the only thing that could do something about the rising price of oil is an emergency Fed meeting where they raise rates by half of a percentage point."

A rate increase by the Fed might be enough to shock the oil market, says Phil Flynn, vice president of Alaron Trading in Chicago. "I would like to see them do a surprise quarter-of-a-point rate increase," he says. "It would show they have inflation-fighting capability.... You have to break the inflation psychology now or later."

An interest-rate increase might also help stabilize the dollar, which sank further after the European Central Bank signaled last Thursday it was likely to raise interest rates to counter inflation. "Europe is not helping out. It's going its own way," Mr. Flynn says.

Last Thursday, the day after the Fed meeting, Chakib Khelil, president of the Organization of Petroleum Exporting Countries, told viewers on France 24 that the price of oil might go between $150 to $170 per barrel this summer. This gave oil prices another boost. "He might be prophetic," Flynn says.

Despite Mr. Khelil's forecasts, however, there were few new developments in the oil markets to suggest that oil prices would go higher. The US Department of Energy reported that inventories of crude oil and distillates were larger than analysts had expected. Fuel consumption fell 2.3 percent in the past four weeks compared with a year earlier.

"Demand is looking pretty weak," says Rick Mueller, director of petroleum markets for Energy Security Analysis Inc. (ESAI) in Wakefield, Mass. "That's why it's so hard to predict prices. It wouldn't be surprising to see the price of crude drop $5 a barrel on Monday."

In fact, energy analysts have been predicting lower prices for some time. In a Bloomberg news survey, energy analysts have called for falling prices in 23 of the past 24 weeks. In the latest survey, almost half of the 24 analysts surveyed predicted lower prices this week.

While the price of oil has been rising, financial stocks such as Citigroup and Lehman Brothers on Wall Street have been falling. "There is the realization we have another round of bank credit write-offs," says Dickson, who notes that a recent downgrade of some banks by Goldman Sachs's analysts "reawakened Wall Street that more write-offs are coming."

Last Friday, the prospect of more bad news prompted Moody's Investors Service to say it is reviewing Morgan Stanley, an investment banking and brokerage firm, for a possible ratings downgrade.

• Wire services were used for this report.