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Nick van der Leek
Thursday, 23 Dec 2010 Consumer behaviour seems to respond to oil price hikes more quickly than in the past |
 Oil has re-entered the US$90s price range in spite of occasional strengthening of the dollar. The reasons include record- setting winter weather in the northern hemisphere, boosting demand for heating oil. What are the implications of these higher energy prices for tottering national economies this time around? In 2009, economist Nouriel Roubini stated that “oil at $145 a barrel was a tipping point for the global economy as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly to $90 a barrel.” Economist Tony Twine says oil prices are behaving more like a currency, but laughs off concerns about oil prices curbing economic growth, suggesting that only at $200- $300/barrel would these concerns be valid. But according to oil industry commentator Andrew McKillop, the tipping point is lower and closer than most people think. Calling this level “the $63trillion question” [a ballpark value for global GDP], McKillop suggests $90/barrel is the trigger price for quite high Keynes-type multiplier effects across the global economy. Beyond $125 there are increasing negative feedback processes, which become very strong at $135/barrel. A source from one of SA’s largest retail banks echoes this figure, but points out current oil expenditures account for only around 8% of gross national spending. While various world economies may show different absolute tipping points, some companies, notably in the airline industry, have more specific and easily identifiable margins. Airline industry expert Michael Boyd calls $100/barrel the critical level where “every airline in the world is obsolete”. McKillop sees “ritual shudders” for world economies starting as low as $100. According to energy economist James Hamilton, oil prices “only start to matter when they make a new three-year high. We probably won’t have to worry about crossing that threshold until June 2011, which would put the big spike in oil prices three years behind us.” When oil expenditures exceed 6% of GDP the US economy tips into recession, he adds. “My guess is $90/barrel would likely put us back above 6%.”
Though Hamilton calls the relationship between oil prices and GDP nonlinear, they have become increasingly linear . From 1991, changes in oil prices and GDP have been more in sync, so that in 1998, 2001 and 2009 further negative fluctuations are clearly synchronised. And in recent months there has been an observable relationship between advancing oil prices and global stock markets — virtually in lockstep. The key variable is consumer behaviour. While a drop in oil prices may not lead to a consumer buying a new vehicle, an increase in prices at current levels of economic sensitivity seems to elicit quicker and more direct consumption declines than in the past. Perhaps the question should not be expressed in terms of an absolute “tipping price” (a narrow definition), but at what point national economies and ordinary consumers show direct attrition from marginal oil prices increases. Arguably, we are in that region of austerity already. Contacted for a comment on tipping point prices, PetroSA said that it did not wish to make any public observations. |
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Nick van der Leek
Thursday, 23 Dec 2010 Consumer behaviour seems to respond to oil price hikes more quickly than in the past |
|
Oil has re-entered the US$90s price range in spite of occasional strengthening of the dollar. The reasons include record- setting winter weather in the northern hemisphere, boosting demand for heating oil. What are the implications of these higher energy prices for tottering national economies this time around? In 2009, economist Nouriel Roubini stated that “oil at $145 a barrel was a tipping point for the global economy as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly to $90 a barrel.” Economist Tony Twine says oil prices are behaving more like a currency, but laughs off concerns about oil prices curbing economic growth, suggesting that only at $200- $300/barrel would these concerns be valid. But according to oil industry commentator Andrew McKillop, the tipping point is lower and closer than most people think. Calling this level “the $63trillion question” [a ballpark value for global GDP], McKillop suggests $90/barrel is the trigger price for quite high Keynes-type multiplier effects across the global economy. Beyond $125 there are increasing negative feedback processes, which become very strong at $135/barrel. A source from one of SA’s largest retail banks echoes this figure, but points out current oil expenditures account for only around 8% of gross national spending. While various world economies may show different absolute tipping points, some companies, notably in the airline industry, have more specific and easily identifiable margins. Airline industry expert Michael Boyd calls $100/barrel the critical level where “every airline in the world is obsolete”. McKillop sees “ritual shudders” for world economies starting as low as $100. According to energy economist James Hamilton, oil prices “only start to matter when they make a new three-year high. We probably won’t have to worry about crossing that threshold until June 2011, which would put the big spike in oil prices three years behind us.” When oil expenditures exceed 6% of GDP the US economy tips into recession, he adds. “My guess is $90/barrel would likely put us back above 6%.”
Though Hamilton calls the relationship between oil prices and GDP nonlinear, they have become increasingly linear . From 1991, changes in oil prices and GDP have been more in sync, so that in 1998, 2001 and 2009 further negative fluctuations are clearly synchronised. And in recent months there has been an observable relationship between advancing oil prices and global stock markets — virtually in lockstep. The key variable is consumer behaviour. While a drop in oil prices may not lead to a consumer buying a new vehicle, an increase in prices at current levels of economic sensitivity seems to elicit quicker and more direct consumption declines than in the past. Perhaps the question should not be expressed in terms of an absolute “tipping price” (a narrow definition), but at what point national economies and ordinary consumers show direct attrition from marginal oil prices increases. Arguably, we are in that region of austerity already. Contacted for a comment on tipping point prices, PetroSA said that it did not wish to make any public observations. |
|
Nick van der Leek
Thursday, 23 Dec 2010 Consumer behaviour seems to respond to oil price hikes more quickly than in the past |
|
Oil has re-entered the US$90s price range in spite of occasional strengthening of the dollar. The reasons include record- setting winter weather in the northern hemisphere, boosting demand for heating oil. What are the implications of these higher energy prices for tottering national economies this time around? In 2009, economist Nouriel Roubini stated that “oil at $145 a barrel was a tipping point for the global economy as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly to $90 a barrel.” Economist Tony Twine says oil prices are behaving more like a currency, but laughs off concerns about oil prices curbing economic growth, suggesting that only at $200- $300/barrel would these concerns be valid. But according to oil industry commentator Andrew McKillop, the tipping point is lower and closer than most people think. Calling this level “the $63trillion question” [a ballpark value for global GDP], McKillop suggests $90/barrel is the trigger price for quite high Keynes-type multiplier effects across the global economy. Beyond $125 there are increasing negative feedback processes, which become very strong at $135/barrel. A source from one of SA’s largest retail banks echoes this figure, but points out current oil expenditures account for only around 8% of gross national spending. While various world economies may show different absolute tipping points, some companies, notably in the airline industry, have more specific and easily identifiable margins. Airline industry expert Michael Boyd calls $100/barrel the critical level where “every airline in the world is obsolete”. McKillop sees “ritual shudders” for world economies starting as low as $100. According to energy economist James Hamilton, oil prices “only start to matter when they make a new three-year high. We probably won’t have to worry about crossing that threshold until June 2011, which would put the big spike in oil prices three years behind us.” When oil expenditures exceed 6% of GDP the US economy tips into recession, he adds. “My guess is $90/barrel would likely put us back above 6%.”
Though Hamilton calls the relationship between oil prices and GDP nonlinear, they have become increasingly linear . From 1991, changes in oil prices and GDP have been more in sync, so that in 1998, 2001 and 2009 further negative fluctuations are clearly synchronised. And in recent months there has been an observable relationship between advancing oil prices and global stock markets — virtually in lockstep. The key variable is consumer behaviour. While a drop in oil prices may not lead to a consumer buying a new vehicle, an increase in prices at current levels of economic sensitivity seems to elicit quicker and more direct consumption declines than in the past. Perhaps the question should not be expressed in terms of an absolute “tipping price” (a narrow definition), but at what point national economies and ordinary consumers show direct attrition from marginal oil prices increases. Arguably, we are in that region of austerity already. Contacted for a comment on tipping point prices, PetroSA said that it did not wish to make any public observations. |
Oil: a long way to go yet
I had an email from a reader this week. He told me that he had sold a two-bedroom flat at the peak of the market in 2007. He bought gold with the proceeds.
This summer he sold the gold and bought himself a four-bedroom detached house. The thinking behind this trade was based entirely on the ratio of UK house prices to gold, which he read about in MoneyWeek in 2007 and on the website House Price Crash.
And it's particularly useful in this era of central-bank-blown inflation. Policy-makers are deliberately devaluing their currencies, which is creating all sorts of distortions. Market ratios can be the lenses which clarify – the de-mister, if you like.
Oil, for example, at about $90 a barrel or so, is trading near its highs for the year. Many would, rightly, see that as a good reason not to buy – indeed, it looks a good reason to sell.
But relative to other markets, there is a strong argument that oil actually could go a lot higher from here...
First let's look at a long-term chart of oil, since 1965.
I subscribe to 'Peak Oil' theory by the way. This is the idea that there is a finite amount of oil in the world, and at a certain point we will be consuming more than we can readily produce. Indeed, judging by all the deep-water exploration that goes on, it's probably fair to say that the easy-to-find oil is already long gone.
However, the inexorable rise you see in the chart above is as much a result of the declining purchasing power of money as it is of oil 'running out'.
There are periods, such as the 1970s, early 1980s and the 2000s, when the oil price races ahead. And there are periods, such as the 1990s, where the oil price trades in a more limited range.
If you measure oil in a currency that governments, for all their efforts, cannot debase so easily by over-issuance – I'm talking about gold, of course – then you see that the oil price has in fact remained in a fairly constant range. Here we see a chart that shows how much gold you'd have to hand over in exchange for one barrel of oil, since 1959.
That chart may look volatile at first glance, but a bit of scrutiny reveals how tight the range really is, unlike oil's inexorable rise when measured in US dollars. How much better for global trade and investment would it be if the price of the world's key commodity were this stable?
Broadly speaking, when you have to pay more than 0.1 ounces of gold for a barrel of oil, gold is cheap and oil is expensive. Below 0.06, oil is cheap and gold expensive. The all-time record occurred at the peak of the oil mania of 2008 when it took almost 0.17 ounces of gold to buy a barrel of oil.
Currently it takes 0.065 of an ounce of gold ($90 divided by $1,400) to buy a barrel of oil. I would say that makes oil fairly, but not extremely, cheap, compared to gold.
This next chart shows how many barrels of oil the Dow Jones (judged by its total points value) can buy you. Again broadly speaking, when that ratio is high, as in around 2000, you want to be selling stocks and buying oil. When it's low, as in the late '70s and early '80s, you want to be selling oil and buying stocks.
The long-term mean is 200 barrels of oil for the Dow. At $90 oil and roughly 11,500 on the Dow, we are currently sitting below that mean, at around 130 barrels. The high point – where stocks were very expensive compared to oil – came at the turn of the century, as oil reached the end of its bear market and the dotcom boom peaked. Then, with the Dow nearing 12,000 and oil in the $10-15 zone, the Dow could buy you as much as 830 barrels of oil.
My thanks go once again to Tom Fischer, professor of financial mathematics at the University of Wuerzburg, for putting these charts together for me. It was Tom who first alerted me to the gold-to-UK-house-prices ratio.
So right now, the oil price looks relatively expensive compared to stocks. Does that mean you should be piling into the Dow?
Perhaps not. Tom is about as extreme an inflationist as you can get. Just as he sees the UK-house-price-gold ratio sinking to all-time lows in the course of this current chapter in financial history, he expects the Dow-to-oil ratio to fall back to somewhere near the lows of the late 1970s and early '80s. Then – with the Dow near 800 and oil spiking to $40 a barrel – the Dow would buy you a mere 20 barrels of oil.
I'm not as convinced as he is that we'll see these extremes. I can see his logic, but when something is trading markedly below its long-term average (as the Dow-to-oil ratio is right now), I'm reluctant to bet too heavily on it falling further.
But 'the trend is your friend' as they say, and this trend, which began in 2000, is clearly heading lower. Should rampant inflation coincide with fast-declining oil reserves, then Tom's target prices will be realised.
This is, of course, a very long-term trade. So – if it appeals to you – there is no rush to go out and do anything right now. And in the short-term the oil price could easily pull back. But one way to play this might be to buy quality oil stocks with growth potential which are not yet at full production. We'll be looking at promising oil stocks in a future edition of MoneyWeek magazine next year – and in the Christmas issue (out at the end of this week) one of our Roundtable experts tips his favourite energy plays. (If you're not already a subscriber, get your first three copies free here.)
Or there is Tom's strategy, which is to buy long-dated, out-of-the-money futures contracts. What does that mean? You buy a contract in the futures market that is not set to expire for another five years or more. That contract is to take delivery of oil at a considerably higher price than now. But you will need a broker who deals in futures. And I should stress that these contracts are only for the experienced – I've never bought one in my life – so buyer beware.
