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"Austrian" Investment Themes

OIL: Prices May Not Be as High as You Think

(This article is also available at Morningstar.com  and Safe Haven.)

There is no question that with gas prices at or near $4.00 a gallon,  a trip to the pump these days is a painful experience.  That said with oil prices (WTI vintage) hovering near  $100 per barrel things are not as bleak as 2008 when prices ran breathtakingly (if briefly) to $147 per barrel. There remains however,  a generally held belief that the price of oil is at or near all time highs in real terms.

Prior to 2008 the peak in inflation adjusted oil price occurred in April 1980 when oil hit 39.50.  In today’s dollars that equates to  $100 per barrel (the 2008 spike in today’s dollars would be adjusted to $150 to account for inflation).

Another commonly held, though controversial, belief is that a Tsunami like influx of speculators (via commodity index  funds and ETF’s), has created an uncontrollable money surge driving oil prices to higher and higher prices.  Former oil trader turned author/and commentator Dan Dickers describes a  process in which “oil’s endless bid drove prices higher throughout the summer in 2008 to an unfathomable $ 147 a barrel with little fundamental evidence to support its rise.” (p7 of link source).

This meme comes from the work of Michael Masters and his testimony before congress in May of 2008.  Indeed any mentions of oil speculation in the main stream media will rely almost exclusively on the work of Mr. Masters (even Mr. Dickers mentions that he relies heavily on this work for his book).  While the general acceptance of Masters’ arguments is a phenomenon worthy of its own discussion, there are plenty of critics.  Even Paul Krugam, who (in his own words) is never shy about discussing his lack of trust in markets, doesn’t buy the Maters story, writing that he thinks his testimony [was] “just stupid.”

An alternative school of thought is that the rise in oil prices is a function of the inflationary forces released by massive money and credit creation, that has occurred not only in response to the 2000 dot com bust and 2008 financial crisis, but in fact has been going on since that fall of the Gold Exchange Standard and the Bretton Woods system in 1971.

One of the flaws of an inflationary policy is that prices do not spread evenly throughout an economy.  If you were to suddenly double the money supply in an economy prices would not respond with an across the board doubling in price of all goods and services, rather some items might remain at the same price while others could triple.

With this in mind, one can reasonably ask:  Is the recent run up in prices a case of oil making new “unfathomable” highs (in real terms) or is it merely a  matter of oil catching up to a more natural price level  relative to other assets?

A look at the S&P 500 to Oil Chart would suggest the latter.

The S&P 500 and Oil Ratio Data includes the annual ratio of the average monthly price of the S&P 500 divided by the average monthly price of a barrel of oil.  The data runs from 1950 to 2010, thus containing 61 “observations” (the lower the ratio the more expensive oil is).  The annual average of monthly prices has the effect of smoothing out some of the noise of volatile market swings.  In 2008 two weeks after reaching $147 a barrel Oil was back at $125 and plummeted down to $33.87 in just six months later.

The ratio during the so called “peak” year of 2008 was 13.3, that is, it took 13.3 barrels of oil to “buy” the S&P 500. Yet there was a total of 17 years (22% of the time) in which oil was more expensive than in 2008 when measured in this fashion.

The real peak year was 1980 when on average it took just 3.2 barrels of oil to match the S&P 500 (The daily closing ratios for these peaks was 2.7 in April 1980 and 8.54 in July of 2008).

If  the price of oil were to return to a ratio of 3.2 in terms of today’s S&P (around 1300), we would see oil trading in the neighborhood of $406 a barrel, a truly “unfathomable” number.

It is of course reasonable to argue that it is highly unlikely to return to such an extreme level in the ratio. As an alternative one could instead look at the median ratio of the 17 years in which oil was more “expensive” than in 2008.  That leads one to the year 1985 when it took 7 barrels of oil to match the S&P 500. A return to the ratio of 7 at today’s S&P level implies a much more plausible, though still frightening price of $185 a barrel.

Another (and perhaps more likely) way to reach such a level in the ratio would be from a decline in the S&P 500 without a corresponding drop in the price of oil. Unfortunately, such a scenario is hardly more comforting.  Were the S&P 500 to decline 25% (to about 975) a ratio of 7 would produce oil at $139.

There is no question that oil is expensive today, and that prices have run up significantly in recent years. However it is easy to forget  just how cheap oil was when this trend of prices began. Indeed in 1998 the average price of oil was $11.91, just some 32% of the nominal peak of $37.42 a full eighteen years earlier.  It would have been nearly impossible to imagine back in 1980 that the ratio of 3.2 would increase some 28 fold culminating in yet another “unfathomable” ratio of 91.4 in 1998.

From an investment perspective what this indicates is that while the easy trade in oil has long since passed, there is still plenty of room from a historical perspective for oil prices to run relative to the S&P 500.

Even more troubling from an investment perspective is  the idea that oil could continue to get more expensive in real terms due to a significant decline in stock prices.  It is hard to see economic growth  accompanying  a further  rise in oil prices.  Worse still, should another economic set back occur it is even harder to see where recovery would come from if oil prices did not contract in proportion to declines in other asset values. That is, it will be hard to recover from a double dip if the economy tanks but oil stays near $100.

There has been a lot of talk in recent years that oil (and commodities) are in a bubble.  The bubble is actually in massive money and credit creation.  First  stock prices were affected, then  real estate.  The recent run in oil and other commodities is no more than a game of catch up.  The nominal price may indeed fall, but don’t be surprised when the S&P 500 / Oil ratio doesn’t reach the levels of 1996 to 2000.

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DISCLOSURE: Barnhart Investment Advisory Model Portfolios, clients and prinicipal hold positions in the iShares Oil Equipment & Services Index ETF (IEZ) and the PowerShares DB Energy Fund ETF (DBE) as of this writing.  Positions are subject to change without notification.

DISCLAIMER: Nothing in this article should  be construed as a personal recommendation or investment advice.  Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any particular investment security.   Investors should conduct their own due diligence and seek the advice of a financial and/or investment  professional before making any investment decisions.


2 thoughts on “OIL: Prices May Not Be as High as You Think

  1. If oil was cheaper relative to personal income, more people would want to use it so we would need to be able pump more out of the ground to fuel the higher demand a lower price would create. Basic supply and demand.

    So if oil is expensive relative to personal incomes, that means supply is limited, because the market price must destroy excess demand over actual supply through higher prices.

    World crude oil supply has been flat since 2004, while demand has wanted to continue its trend of every increasing growth as population and wealth grow. Since oil suppliers have either not been able to or not seen fit to pump more oil out of the ground for 7 years straight now, excess demand has instead been destroyed by an ever higher market price. No more lazy Sunday drives or 10 mpg monster SUV’s, more people unemployed as marginal business and commuters are squeezed out of the eocnomy by high prices.

    Much of the oil in the world is pumped out by market oriented corporations like Exxon or BP or Shell and the rest by various tinpot dictators interested in aggrandized personal wealth. If the corporations are not pumping more oil and are actively closing refineries because there is no oil to refine in them, why do people suppose they are doing this except that they have hit the wall with supply? If Iran, Saudi Arabia, and Venezuela, for example, cannot match their supply peaks of the 1970’s what makes people think they are purposefully witholding oil when they could sell it for record prices when a few hundred thousand extra barrells would just disappear into world demand and earn them billions? If Mexico and the North Sea countries simply cannot counteract the decade long decline of their oil field production when there are record profits to be made, what makes anyone suspect they are just not working hard enough to pump oil?

    The logical answer to all of this is that supply cannot be increased further due to natural limitations and that demand balance is being restored through ever higher prices.

    Economics 101 and Occam’s Razor. Don’t overly complicate the problem.

    Posted by Andrew | July 29, 2011, 1:22 PM
  2. Hi Andrew,

    I don’t disagree with anything you wrote, but I do disagree with what is omitted. A key factor in the price of oil (or anything) is supply/demand dynamics of the money that is used to buy the oil.

    The supply of money and credit has grown substantially, but has not flowed “evenly” across prices for various goods and services.

    Whether oil trades at $200 or $50, if the ratio of prices continues towards the historical levels of say 7 barrels of oil to the S&P 500, oil economics will be more painful in real terms than they are now.

    Posted by Ted Barnhart | July 29, 2011, 2:24 PM

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