Will Rising Oil Prices Prevent a Recovery?

By Dirk van Dijk, CFA

The following two charts (and the comments in between them) are part of a very interesting article by James Hamilton. The collapse in oil prices last fall acted as a key economic stabilizer and helped ameliorate the economic decline.

It showed up in two key places. The first was in the trade deficit numbers, which have shown a very dramatic improvement over the last year (see here and here). The other place it showed up was in retail sales, since a dollar spent at the gas pump is a dollar that can not be spent elsewhere.

Since last Christmas, prices at the pump have climbed sharply, as shown in the first graph. While prices are still far below the levels of a year ago, the current levels are high enough to start hurting, especially those who have seen their incomes drop due to the recession. Dr. Hamilton calculates that the current prices would be consistent with energy taking up over 6% of total personal consumption expenditures, up from 4.85% back in December.

As the second graph shows, that would be about the share of spending energy had back in the mid-1980’s. The mid-1980’s were not exactly the worst period of our economic history, so such a level in and of itself should not be a real problem for the economy. And we faced a far more serious problem with energy prices in the 1970’s than we did even at the worst energy price levels we saw a year ago.

Still, this is coming at a time when the economy is still very fragile. Retail spending on goods other than energy face strong headwinds from both the need for consumers to rebuild their personal balance sheets (pay down past debts and build up savings) and from much worse personal income statements (unemployment, hours and wages cut, lower interest rates on savings). This is just one more unhelpful factor that will pressure sales, particularly for stores that sell discretionary items, including clothing stores like The Gap (GPS) and appliance stores like Rex Stores (RSC) and HH Gregg (HGG). Higher oil prices are of course good news for the energy sector, but for the overall economy high energy prices are a significant negative.

The rise in oil prices does not seem to be consistent with the overall weakness of the world economy, but there are several reasons why it just may be sustained or extended, even in the absence of a global economic rebound. The first is that oil is a good hedge against future inflation, and given the expansion of the Fed balance sheet, that may be a very serious concern down the road. Currently the bigger threat is deflation, but it will be hard for the Fed to sop up all the liquidity that has been created to fight the deflationary fire.

A second and somewhat related reason is that China has been increasing its purchases of all sorts of commodities, trying to take advantage of the lower prices (note that the price of other commodities like copper have also increased sharply from the lows of last winter, but remain well off the highs of last summer). OPEC has also shown greater discipline this time around than they have in the past. How long that will last nobody knows, but so far they have been keeping it together.

The third reason is that the looming danger of peak oil has not gone away, it has only been masked by "peak demand" caused by the economic downturn worldwide. Any incremental oil is now coming from very expensive sources like the Canadian oil sands or the very deep waters of Brazil, both of which require oil prices in the mid-$60’s to be economically viable.

With oil prices rising above those levels, the drilling off Brazil should pick up steam. There are, however, very few rigs capable of drilling at such depths. Most of those are controlled by two firms, Transocean (RIG) and Diamond Offshore (DO), both of which will benefit enormously if oil prices stay high.

In short, the current levels of oil prices are not exactly fertilizer for the "green shoots," but will not kill them off either. Other developments, such as long-term interest rates, will have more of an impact. The very low prices at the pump in the first quarter may have been one of the key reasons why consumer spending in the quarter was higher than expected (but probably not as big a factor as increases in transfer payments). However, if they continue to rise towards the $100 level, the world economy could easily fall back into the abyss.

National average U.S. gasoline retail price. Source: NewJerseyGasPrices.com.

The 16% increase in gasoline prices between December and February resulted in an additional $37 billion spending by consumers at an annual rate on gasoline and fuel oil, increasing the share of energy purchases in consumer budgets from 4.85% in December to 5.17% in February. The additional 40% increase we've seen in the retail price of gasoline since February has likely brought that expenditure share back up above 6%.

Comments

[William Montague]

This is not a demand led rally in oil, there are tankers across the world, sitting, waiting for demand to come back, production hasn't been reduced.

This is another bank led boost in oil prices, Morgan Stanley, Citigroup, JPM have even bought tankers themselves and filled them with oil waiting for a time to sell (as well as their futures holdings).

Morgan Stanley, Citigroup Inc, Royal Dutch Shell Plc

www.oilandgaseurasia.c...

JPMorgan

www.reuters.com/articl...

They need prices to go up so:

a. they can make a tidy profit.
b. they can start claiming inflation is on its way.

2009 Jun 10 09:23 AM

[Mad Hedge Fund Trader]

Too rich for me! Get me out of oil! I love a core long position in this commodity (see madhedgefundtrader.com...), and expect it to hit $200 before I join the AARP. But we have really gone too far, too fast, and are seriously in overshoot territory. Industry traders have been taking advantage of the greatest contango of all time, buying the front month contract, taking delivery, keeping it in storage, and reselling it forward to reap returns of up to 50%. And that is without leverage! Clever analysts are resorting to Google Earth to spy on storage facilities via satellite. Non industry players have been buying it as a dollar replacement. Crude burns better than dollar bills. As a result, crude in storage has ballooned to record levels. All fine and good when the price is going up. But crude can’t stay this high once the sugar high that is sustaining the economy burns off. Better to bail now at $70 and buy it back at $50 once reality sets in. And for Heaven sakes, don’t try to get to clever by shorting the stuff!

2009 Jun 10 10:21 AM

[Dave Wrixon]

Yeah, in a Keysian recovery drilling should be spread out according to need in society. No need to waste money on geologists. If unemployment is highest in Detroit, that is where the drilling should be undertaken. Besides Rockafellar probably didn't leave anything in Texas anyway. Get Bush back, he is a dry well specialist!


On Jun 10 09:36 AM doubleguns wrote:

> No you are not NED, you are cetin!!!
>
> I think the rise in oil is simply a reflection of the weakening dollar
> with speculation added in.
>
> We need to drill, drill, drill and create some jobs here in our new
> socialist Amerika.
>
> A jobless recovery will simply fall right into the socialists plans
> to continue to socialize Amerika even more.
>
> Things are not looking good.
>
> On Jun 10 09:16 AM dreen wrote:

2009 Jun 10 12:03 PM

[Dave Wrixon]

On a serious note, no it is not Oil that is going to be the main stick in wheel although it certainly won't help. Higher, interest rates imposed through market forces due to foreign banks dropping US debt, thereby driving the dollar lower will cut of the capital investment that has yet to materialize anyway.

2009 Jun 10 12:06 PM

[Maxe Paul]

The short answer is YES, and the long answer is YES IT WILL.

Oil (i believe) is in a bear market rally and is maybe looking to do a 38.2% Fibonacci retracement to $78.78, or we are not ruling out a 50% at $92.19.

There is no chance of this endless price rise being sustained on maco, technical, fundamental, supply basis, subversive mind control, hypnosis, CNBC pumping or any other load of complete gobbly gook that the nice men in suits at Goldman Sachs would have you believe.

PS: I just heard a guy on Bloomberg say "buy oil", so add them to the list also!

2009 Jun 10 12:28 PM

[Just Say Whoa!]

>Will Rising Oil Prices Prevent a Recovery?

No.

This concludes another edition of "Simple answers for simple minded questions"...

2009 Jun 10 01:02 PM

[squark62]

>Will Rising Oil Prices Prevent a Recovery?

probably, but not by itself. we're following nearly the exact same trading pattern as in 2008. as the market starts to go down, the price of oil (& other commodities) will continue it's price trajectory upward.

2009 Jun 10 01:17 PM

[tunaman4u2]

YES

2009 Jun 10 01:41 PM

[Whippet]

Oil prices are irrelevant to the recovery we may have. The "rate limiting" factor in our recovery will be credit liquidity, as that is what has us in this mess. When this is "solved", the new rate-limiting factors will be inflation and astronomical interest rates. After this, my crystal ball gets cloudy.
Oil has rallied due to the Green Shoot Jedi Mind Tricks, inflation fears, and probable NYMEX futures gamesmanship. I agree with MHFT; this will short-term correct and long-term be a multi-bagger. In an "L" shaped recovery, surviving firms and consumers will be forced to economize, and will move to natural gas, coal, and wood as replacements for expensive oil, at every substitution point. Our disintegrating greenback will make these decisions even easier. Oil will only be used for the highest value-added end uses in a weak dollar Republik of Amerika.

2009 Jun 10 03:23 PM

[Philly Jim]

A dictator's dream... $100+ oil

2009 Jun 10 09:02 PM

[Peter Cooper]

This article is right on the money - I am afraid the quick return of higher oil prices heralds a second down leg to this recession which is far from over, see:
arabianmoney.net/2009/.../

2009 Jun 11 12:21 AM

[Ferdinand E. Banks]

If you have read enough macroeconics in the business press, then you know that in the past rising oil prices have been bad macroeconomic news. The only sensible conclusion at the present time is that everybody might be hurt if the oil price continues up, where everybody includes the oil producers.

2009 Jun 11 10:35 AM

[Mad Hedge Fund Trader]

Definitely. I chatted with Jeff Rubin last night, former chief economist with CIBC World Markets, who reaffirmed my own hyper-bull case for crude in bucketfuls. He was in San Francisco, admiring our civic planning and mass transit system, as part of a tour to promote his new book “Why Your World is About to Get a Whole Lot Smaller: Oil and the End of Globalization.” We are in the bottom of the ninth inning of the hydrocarbon age. The next super spike will take us to over $100/barrel within 12 months of the beginning of an economic recovery, and much higher after that. The problem is that we are losing 4 million barrels/day through depletion just when demand is increasing. The only offset will be dirty, foul, huge carbon footprint, $100/barrel Canadian tar sands, which will double, to account for 40% of our imports. The biggest increase in consumption is in OPEC itself, where consumption has ballooned to 13 million barrel/day and oil is being wasted on a prodigious scale, compared to only 7 million b/d in China. Gas there costs only 25 cents/gal, utilities in Saudi Arabia pay only three cents/gallon for bunker fuel, and Dubai is blowing 3,000 b/d equivalent running an indoor ski resort. Oil over $100/barrel will bring globalization to a screeching halt. Economies will go local because it will cost too much to transport goods, as we have in the past. No more California avocados in Toronto. More importantly, no more Chinese steel in the US, or any other heavy exports, which will lead to a resurgence in domestic manufacturing and the jobs that come with it. Last year $90 of the $600 cost of Chinese steel went to shipping costs. $10/gal gasoline will take 50 million of our 240 million cars off the road. Even if we replace them with electric cars, we don’t have the power grid to juice them. Chinese exports will collapse, but so will their Treasury purchases, meaning no more bailouts for us. Oops. Subprime neighborhoods will get plowed back into farmland so we can eat. I think Jeff is dead on about oil prices. But as necessity is the mother of invention, some of his predictions about their impact on international trade are a bit extreme for me.

2009 Jun 11 10:37 AM

[root]

Thats probably the most unintelligent thing I have ever read. Sure I agree with you about the weaking dollar and speculation but bring some base to your arguement. Instead of ignorant rhetoric.


On Jun 10 09:36 AM doubleguns wrote:

> No you are not NED, you are cetin!!!
>
> I think the rise in oil is simply a reflection of the weakening dollar
> with speculation added in.
>
> We need to drill, drill, drill and create some jobs here in our new
> socialist Amerika.
>
> A jobless recovery will simply fall right into the socialists plans
> to continue to socialize Amerika even more.
>
> Things are not looking good.
>
> On Jun 10 09:16 AM dreen wrote:

2009 Jun 11 10:55 AM