The recent declines in the various markets, attended by the continued increases in oil prices (as reflected here by the performance of the commodities markets in this chart), have most observers concluding that the two are strongly connected. I agree; Investors, seeing rising oil prices, expect higher inflation and narrower profit margins for companies. This has led them to allocate more of their portfolios to commodity investments, cash and less to equities. This has been a trend over the last few years, and as George Soros observed to congress, has likely been at fault for the closely correlated climbs in several commodities. This naturally leads one to ask why we aren't following so many of our peers and doing the same. Ultimately, this is because I don't expect oil prices to remain this high and expect that most commodities will eventually reverse course. This is not to say that we don't have some clients invested in commodities, just not most and generally not those with very long time horizons on their portfolios.
Someone asked me the other day when I thought that oil prices were likely to decline. As anyone who knows me can attest, I've thought that the price of crude oil was artificially high for several years now and been consistently incorrect in my assumption that oil would eventually return to its "fundamental value" - a number that is generally quoted by oil industry leaders as somewhere between $45 and $65 a barrel. So, while I haven't known when oil would decline, I have been confident that it eventually would. Speculative bubbles always come to an end, and its best not to try and invest once one has begun. But oil prices have continued to increase, understandably testing the patience of many.
High oil prices have finally started to impact the American consumer. Increased gas costs have started to weigh on the national psyche. But, as the upward revision of GDP last week and higher rates of increase in consumer spending last month show, the stimulus package checks (and their expectation of arrival) have translated to stable growth in the short term. The consumer is generally holding up, however different industries (and companies) are responding differently. Clearly, the American consumer is starting to change their purchasing habits, but this hasn't translated into substantially lower spending. And what that largely suggests is that consumers will be changing their spending habits as their preferences adjust to different, more energy efficient products. Businesses are likely to follow suit, but in the short term, higher energy costs are likely to either contract profits or create inflation. It currently seems to be doing a bit of both.
The concerns of most bears in the market currently relate to a repeat of the 1970s - a dark and dismal period for just about everything but film that was characterized by high inflation, low growth and just about every number that you want to be high, being low, and every number you want to be low, being high - and getting higher. Early in the 1970s, oil prices increased dramatically and remained persistently high throughout the decade. The economy did poorly for most of the decade. But, energy prices may not have been as big of a deal as previously thought. In fact, so much went wrong in the 1970s, that it's unlikely any single cause can be seen the primary driver for the long recessionary conditions of the period.
As the relatively good economy since 2001 (the point when prices started to increase) attests (low inflation, decent growth and low unemployment), oil price spikes don't necessarily need to result in a recessions. Their cause is usually political, not economic; The oil price spike in the 1970s was a product of a foreign policy gambit by the Arab nations to force the US and Europe to drop their support of Israel in the wake of the Yom Kippur War. There wasn't a dramatic increase in oil consumption or a reduction in supply, but rather, a "shortage" was created for the purposes of forcing a policy change in Washington by disrupting the lines of supply, which adjusted themselves away from the Middle East for those countries (namely, the US) under the embargo.
The potential for Soviet intervention limiting their foreign policy alternatives, the Nixon Administration's response was to support price control measures on oil which were designed to encourage exploration, but ended up creating artificial shortages. Companies found selling "old oil" to be far less profitable then considerably less "new oil". The perverse incentive to produce less crude resulted in actual (but temporary) shortages of gasoline. Gas quickly was rationed in a way that was reminiscent of World War II. The government began advertising campaigns to encourage Americans "not to be fuel-ish". Rather than giving Americans a sense of comfort that their government was responing effectively to the energy crisis, the general interpretation of events was that the US was considerably less powerful internationally than previously thought and presumably couldn't be expected to maintain stable supplies of foreign oil. This terrified people from Main Street who then began to buy up gasoline to hoard and to Wall Street buy up oil futures to hedge.
The Saudis, the largest producer, caved under the eventual cost of the embargo. Ultimately, the relative strength of the United States as a commercial power triumphed. The Israelis won again and the balance of power in the region shifted from the to the United States. By the late 1970s Saudis had chosen to dramatically adjust their foreign policy towards an effectively vassal state status with the US.
The subsequent Energy Crisis of 1979 at the start of the Iranian Revolution was considerably less challenging for two reasons - firstly, the supply lines had become considerably more flexible in the wake of the experience earlier in the decade and secondly, the response by the government was considerably less dramatic. Once again prices spiked up and eventually came back down.
But the economy did very poorly in the 1973-1981 period and this is where a strong link was established between energy prices and future economic performance. A view I shared, until recent economic performance demonstrated that the relationship between crude oil prices and GDP growth was not necessarily causal.
This time around, energy prices have been driven by several factors, but most of all, they have been driven by spectacular growth in India and China and generally good growth in the rest of the world. This growth has allowed purchasers the ability to afford high prices for petrochemical products. Probably, this strong growth has allowed speculators to drive the price up to current levels. Regardless of whether that's true, the difference between now and 1973 is that the source is actually economic - too much demand. Back then, it was a product of politics. If we believe that supply and demand are related, it's safe to assume that if prices remain persistently high, consumers will adjust their preferences and buy less oil. This should in turn reduce the demand and the supply will increase, leading to lower prices.
The responses that I hear to this fairly obvious reasoning generally argue the while this may happen in the United States, China and India's economies will continue to grow and their demand for oil will as well. This ignores the fact that both these economies are primarily growing through exports. It is difficult to imagine either country ramping up sufficient domestic demand to make up for the loss of growth in their export markets - namely the United States and Europe. We are all interconnected. A much more likely scenario is that growth will more likely be severely impacted in those countries than the US, where domestic demand is the primary driver of an expanded economy. It is for this reason that I am increasingly concerned about the impact on rising energy prices on the emerging markets than the developed.
