The price of oil has broken through $55 and continues to hit new highs. In fact, oil prices have increased over 70% this year for three main reasons: there have been few new discoveries of oil in recent years; there is greater demand for oil, especially from China, who is now the world\u2019s largest importer of oil following the United States; and there is uncertainty over oil supplies because of war and terrorism.
In the past 30 years, higher oil prices were followed by recessions in 1973, 1981,
1990 and 2000. Higher oil prices have historically led to recessions because they act as a
tax on spending by absorbing consumer dollars that would be spent elsewhere, by
reducing corporate profits through increased costs and lower demand, and by causing
higher inflation which in turn causes higher interest rates.
Higher oil prices cause a supply shock that reduces GDP while simultaneously
raising inflation. This is what happened in the 1970s when the world was hit by
stagflation, and when accommodative policies by central banks pushed inflation and
interest rates even higher.
The oil shocks of the 1970s and 1980s had a devastating impact on investors. 10-
year US Bond yields rose from around 6% to 15% imposing losses on fixed-income
investors. Stock market investors also lost money. For example, the Dow Jones Industrial
Average lost nearly 75% of its value, after adjusting for inflation, between 1966 and
1982, its worse decline since the Great Depression. Depositors suffered because interest
rate controls prevented them from getting adequate returns on their deposits.
During the 1970s, there was no place to hide. Whether investors had their money
invested in stocks or bonds, they lost money. Should investors today have the same
The impact of higher oil prices on the economy and on investors is more complex
that it would first appear. That is why taking a full global and historical perspective on
the price of oil is important. By looking at historic oil prices, stock prices, interest rates,
inflation rates and other financial and economic data in the Global Financial Database,
we can provide some analysis to help investors.
Increases in oil prices impact some economic sectors more than others. Investors
need to change their sector allocations in response to higher oil prices. Oil stocks, for
example, have been breaking out to new highs for the past two years. This also happened
in the 1970s when oil prices increased previously. Oil stocks outperformed the rest of the
market between 1973 and 1980 when the price of oil was rising, but underperformed the
rest of the market between 1980 and 2000 when oil prices declined. A continuation of
strong performance in the oil stocks will depend upon whether the price of oil continues
on this uptrend.
Additionally, investors should consider the impact of higher oil prices on other
sectors. The airline and auto industries, which are heavily dependent on oil, have faltered
during the past two years, just as they did in the 1970s. Internet retailers, such as
Amazon, should benefit from higher oil prices because consumers won\u2019t drive as much as
they used to.
The impact of higher oil prices on the stock market is smaller than in the 1970s.
Energy costs\u2019 share of GDP has fallen from 8% in 1973 to only 2% today. The global
economy relies more on services today than in 1973 and higher oil prices have made the
world more energy efficient. Increased demand from China has contributed to the rise in
commodity prices, including oil, during the past five years. China needs more oil to
produce the vast amount of goods it is exporting to the rest of the world. Though oil
prices are higher, Chinese exports have reduced the price of manufactured goods
benefiting consumers throughout the world. Every change in the global economy has
costs and benefits and the key to successful investing is to determine where those costs
and benefits occur.
To measure the overall impact of China\u2019s entry into the world economy, you have
to look at the impact on both commodities and manufactured goods. China has moved
the terms of trade in favor of countries exporting commodities and importing
manufactured goods, such as Australia, while moving the terms of trade against countries
importing commodities and exporting manufactured goods, such as Bangladesh.
This trend is likely to continue. Therefore, investors should be aware of the
impact this will have on the price of equities. Investors should increase investments in
countries, such as Australia, that benefit from higher commodity prices and lower prices
for manufactured goods while reducing investments in developing countries that must
import oil and compete with Chinese exports.
One surprising difference between 2004 and the 1970s is that despite higher oil
prices, interest rates have not increased. Typically, a supply shock both raises prices and
reduces output; however, this time inflation has not risen significantly, and long-term
interest rates have actually fallen.
Lower interest rates signify that the inflationary impact of higher oil prices will be
minimal. The bond markets do not expect the higher oil prices to trigger an inflationary
spiral similar to the 1970s. The good news is that fixed-income investors need not fear
the impact of higher oil prices on bonds as much. The smaller role of energy costs in
GDP, the larger role of services, and the deflationary impact of greater manufactured
exports from China along with less accommodative monetary policy have reduced the
inflationary impact of higher oil prices.
The supply and demand for oil are both inelastic in the short run causing the price
of oil to be volatile. This explains why the price of oil can increase by 70% since
December 2003. Changes in the supply or demand for oil can cause dramatic shifts in the
price of oil, either higher or lower.
Higher oil prices spur more exploration for oil, increase the demand for oil
substitutes, and encourage oil conservation. Historically, oil prices have increased
sharply, and gradually declined as supply caught up with demand. Oil prices increased
rapidly in the 1860s, the 1910s and 1970s only to be followed by declining prices in the
decade that followed these periods. This is because the supply and demand for oil are
more elastic in the long run, making the price of oil more stable in the long run.
Oil prices have been rising since 1999, but the impact has been quite different
from the 1970s. For the reasons given above, the impact of higher oil prices on investors
is likely to be less severe than in the 1970s. Also considering the behavior of inflation
and exchange rates in the past, we will see that history reinforces this conclusion.
To adjust for inflation we converted the historic price of oil into 2004 prices. We found that the average price of oil during the 20th Century, as measured in 2004 prices, was $23. The real price of oil fluctuated between $10 and $20 until the 1970s when the first oil crisis hit. Since 1973, the average real price of oil has been $38.
After 1972, the price of oil increased more than five fold, rising from $15.50 in
1973 to over $83 in 1981 as measured in 2004 prices. The price of oil slid for the next 17
years, bottoming out at $13 per barrel in November 1998. Adjusting for inflation, this
was the lowest the price oil had been since the 1940s.
Since November 1998 the price of oil has risen steadily from $11 in 1998 to $56 per barrel today. There was an initial increase in price between November 1998 and June 2000 when oil rose to $35 per barrel, and a second increase from November 2001 when oil rose from $20 a barrel to $55 today.
Although the current price of oil is at an all-time high, after adjusting for inflation,
oil is still cheaper than it was in 1981. In fact, the price of oil would have to increase by
50% from its current price of $55 to return to the equivalent of its 1981 levels. Given the
psychology of markets, if the price of oil were to increase to $83 a barrel, what would
keep it from going to $100?
Nevertheless, at $55 the current price of oil is 50% higher than the average price
of oil since the oil shocks of 1973. Oil prices have been rising for six years now, which is
above its long-term average. Although the price of oil could still rise further, in the longer
term the price of oil is more likely to retrace to the $30 range. Looking at the historical
behavior of the price of oil, it would appear that most of the increase in the price of oil
has already occurred, and probabilities favor that five years from now the price of oil is
more likely to be below today\u2019s price than above it.
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