Oil prices

In the past 12 months, the price of oil has more than doubled. At a record $140 a barrel in mid-June, it’s up 47 percent since the start of the year. Although nobody knows the future, there are plenty of reasons why oil prices may continue to keep rising, although perhaps not as rapidly as we’ve seen recently.

There’s no great mystery behind the rising price of oil. In a nutshell, there are four components. Demand is rising rapidly in developing nations, notably China and India. Known and anticipated oil supplies are limited. Investors and speculators who buy commodities are adding fuel to the demand. Since oil is priced in dollars, the depreciating greenback has also contributed to the rising price of oil.

While the third and fourth components are subject to change at any time, the first two are likely to continue.

Per-capita incomes are rapidly rising in China, India and other developing countries, making automobiles and trucks affordable to millions of people to whom they were previously out of reach. Countries in the Middle East are building an industrial base that will significantly increase their demands for fuel. Ironically, this reflects strong economic growth which has been stimulated by the very same high oil prices.

Some emerging countries are increasing their strategic stock of oil in order to build up reserves. Institutional and individual investors are increasingly allocating some money to commodities, including oil.

Oil supplies aren’t expected to keep up with all this demand. The Wall Street Journal recently reported that the International Energy Agency, an independent energy advisor, was preparing a pessimistic outlook on oil supplies.

This spring, Goldman Sachs cited tight supplies as one reason for forecasting U.S. crude oil prices of $141 per barrel in the second half of 2008, a sharp increase over its previous forecast of $107. By mid-June, the price had already reached $140. Goldman Sachs predicted the price could go to $200 within the next two years.

Fortunately, the economy can be expected to apply some natural “brakes” to the skyrocketing price of oil. Consumers and businesses are already scrambling to conserve energy, and that is likely to continue. Newer vehicles are generally more fuel efficient, and as gas guzzlers become less popular, fewer of them will be manufactured. At some point, high prices will prompt more and more people and businesses to find ways to “just say no” to activities that require petroleum products. And alternative energy sources will make more economic sense.


Impact on the economy

If the price of oil continues to rise, what would the potential ramifications be for the economy and the markets? Obviously, high oil prices could lead to lower consumer spending, weaker economic recovery and higher inflation in the United States and other developed countries. However, oil prices are far from the only major things that affect the economy.

Recent history points to an uncertain correlation between oil prices and recession. This country has experienced six recessions since 1970. Two of them came after large rises in the price of oil, in 1973-74 and in 1979. Two other recessions had preceding or coincident oil price rises, but those prices declined during the recessions. Before the recessions of 1970 and 1982, oil prices were either stable or fell.

Higher oil prices may contribute to inflation, which could prompt the Federal Reserve to start raising interest rates.

Elsewhere in the world, emerging countries that are blessed with oil supplies, for example Venezuela, Brazil and Russia, may benefit from higher prices. Countries that must import oil – Japan is a prominent example – may be negatively impacted. That pinch may be felt especially by the poorest members of society.

There could be an increasing chance that countries may let their currencies appreciate against the dollar to contain their own inflation.

Finally, there is even more incentive to develop alternative energy supplies.


What history tells us

Many readers may recall the energy crisis of the early 1970s, when the federal government imposed a mandatory 55 mph speed limit on all highways and some pundits predicted the doom of modern civilization.

In 1973, the price of oil more than tripled, resulting in a condition that was called stagflation, the combination of stagnant growth and high inflation. (Fortunately we are not seeing that combination with the same magnitude in 2008.) From 1973 to 1980, the price of oil rose from $5 a barrel to $40; the country also endured two recessions and a severe bear market in 1973 and 1974.

One of my colleagues vividly recalls that in 1974, Money magazine published a cover story essentially declaring the end of the stock market as a viable source of gains for most people. That prediction seemed to have lots of evidence behind it.

But reality didn’t conform to the magazine editors’ views. Even including the sharp bear market years of 1973 and 1974, the U.S. stock market did well during the 1973-1980 time period. Here are the results of four asset classes: 

Conclusion

It seems fairly obvious that oil prices will continue to have an important effect on the economy. But the effect on investment markets is hard to forecast. Energy is only one of a multitude of factors that make investment values go up and down over time.

In the real world, it’s very difficult to predict the future price of anything, especially something as volatile as oil. And it’s even tougher to foresee the impact that any oil price change may have on long-term investment values. Capitalism and the stock markets have survived world wars, depressions, recessions, periods of high inflation, oil embargos, Pet Rocks and Teletubbies. Markets and economies learn to adjust and, over the long term, stock markets have continued to appreciate.

Our clients’ portfolios are invested in a wide variety of market sectors. Many investments in the industrial material and energy sectors will benefit from rising energy prices. We believe the best investment strategy for the long term remains a well diversified portfolio, with exposure across many asset classes including small-cap stocks, value stocks and international stocks, as well as appropriate allocations to some asset classes, such as TIPs and REITs, which could potentially benefit from inflation.

Even though it won’t help you at the gas pump, I believe that in the long run, a carefully built portfolio that includes all those elements is your best bet.

Larry Katz is the Director of Research at Merriman