One of the things I’ve had my eye on in the last week is crude oil. It's quietly sneaking back up towards $90 per barrel. At first the rally had pretty much everything to do with dollar weakness, but last week the dollar strengthened a little bit and crude continued to climb. It got clobbered last Friday, but interesting, the dollar sold off Friday as well.
What's going on here?
According to a recent Commodities Futures Trading Commission (CFTC) report, the number of net long positions in crude oil held by hedge funds is at an all time record. Hedge funds don't have the best reputation in the financial industry but just about everybody in finance agrees (if begrudgingly) that the hedge fund space is where the best talent and intellect lives. They are the professionals that take money from the amateurs. They're probably betting on high crude oil prices for a good reason.
Obviously, a pickup in speculation could be one factor pushing energy prices higher. That's all well and good for investors, but this could be a bit of a concern for the rest of the world. Investors everywhere have been chasing any asset that's going up and more chasing of crude oil could have detrimental effects on the real economy. I'll explain.
Crude oil is an interesting thing to watch. Because it's a relatively inelastic good, it has an interesting relationship with the economy and stock market. At low and tolerable levels, crude oil tends to correlate with stocks and the economy. There's a good reason for that. When people are feeling good and the market is rising they use more energy. But when oil prices rise beyond a certain point, it starts to have a negative effect on consumer psyche. They're forced to spend a greater portion of their income on energy and cut back in other areas which have a detrimental effect on the economy. The relationship is sort of parabolic.
The slippery thing is that this relationship is difficult to quantify and this knock-on threshold changes over time as prices inflate and consumers adjust to new market equilibria. Since 2006 the point to watch has been around $85/barrel. Below that level the daily correlation between crude oil and the Dow is about 0.36 -- not super meaningful but it is modest positive correlation. Above that $85 threshold is where it gets interesting. The correlation collapses to almost zero. Again, not tremendously meaningful but it's clear that something breaks down when crude oil gets expensive, or a related, hidden exogenous factor comes into play.
As an anecdote, consider the 2001 recession where oil prices shot from $13 to over $30 in the two years prior. Energy prices played a role in that recession. Or the 1970's where fluctuating oil prices wreaked all sorts of havoc on the economy. And by the opposite token, consider the striking rebound in energy prices exactly alongside the economic recovery of 2009. People started to feel OK about filling up their SUVs again.
Keep your ears open
Anyway, we're at the point now where it's time to start paying closer attention to crude. We're about to cross the threshold where the tight correlation that we've seen for the last two years may start to break down. And there's a cultural milepost as well; make note of how often people complain about high gas prices. For the last year or two nobody has been complaining too badly. Keep your ears open.
The energy sector is one of my favorite areas of the market and has been for quite some time. I see it benefiting in so many different scenarios, everything from depletion of natural resources to inflationary panics to the powerful intrinsic demand for the goods they produce. Exxon (XOM) has a dividend yield comparable to the 10-year Treasury and other names in the space offer even juicier yields. Royal Dutch Shell (RDS.A) pays a 5% dividend and Chevron (CVX) yields 3.4%. You can obviously grab them all with an ETF like XLE (XLE), but you'll lose a bit of that dividend yield.
Don't neglect the natural gas producers like Chesapeake (CPK) or some nuclear power providers like Exelon (EXC) -- we published an extensive report on uranium and the nuclear industry right here.
All these firms can win together.
Disclosure: Long XOM