Are We in a Recession? | The Answer Hinges on the Price of Oil

A re we in a recession? How bad will it be? How long will it last? Everyone in the investment world is asking these questions. The answers all seem to coalesce on one word, oil.

During the spring, just as oil reached $120 a barrel, someone asked petroleum guru T. Boone Pickens where he thought the price of oil would go. His reply: $150 a barrel. For a time after that, some people in the investment world seemed to be walking around as though stakes were pounded through their hearts.

For oil to rise, to express it bluntly, excess production capacity must be scarce. For most of the last century, specifically from 1933 to 2004, the excess capacity came from either the state of Texas or OPEC. They were what became known as the “swing producers.”

They held production off the market to keep prices higher than a completely free market would generate. What the economy gained from the swing producer was the existence of excess capacity, which could be brought to market to offset a spike in prices. Consequently, when we did see spikes in prices, they could be shortly offset.

However, in 2004, we began to see that the combination of rising demand from emerging markets and the lack of investment in refining production had exhausted OPEC’s excess capacity. So, as oil prices rose, the cartel was unable to bring enough supply to market to lower the price.

Given the fact that current supply is constrained, the only way to reduce prices significantly is by weakening demand. In the long run, this will be accomplished by technologies that reduce consumption. One example is the development of the hybrid car that uses both gasoline and electricity. That would be a bearish event for the price of oil.

We expect such cars to be readily available over the next two years. Over the next decade, their widespread use both here and abroad will likely ease demand for consumption.

In the short run, there appear only two factors that could force oil prices lower. The first would be slower global economic growth. Although U.S. oil consumption has been falling, global demand continues to rise.

What is unknown is whether or not oil prices have increased enough to weaken the global economy and press demand lower. A recent oil-supply chart suggests the term structure of oil is signaling plentiful supplies, which should help contain prices.

The second factor would decisive support for the dollar by the G-7. Oil is denominated in dollars, and one reason for rising oil prices is the weakness of the dollar. Although the ties between oil and the dollar long term may be tenuous, a stronger dollar would weaken bullish psychology surrounding commodities and consequently push the price of oil lower.

Usually, the current price of oil trades at a premium to long-term contracts. According to research at Wachovia Securities, from 1982 to 2004 this happened 73 percent of the time. When current oil prices trade at a discount to the longer contracts, folks in the know call this a contango.  

In general, a contango is a bearish condition for oil prices because it signals plentiful, prompt supplies. From 2004 until mid-2006, inventories were building, and the market went into a persistent contango.

The oil market’s recent move into a contango could signal that the currently rising market could be facing some headwinds. In effect, the contango market suggests that current supplies are adequate, which is depressing the nearby oil market compared to later ones.

Although the development of a contango in this market usually means the price of oil will go down, it may take some time for the forces that have making the price increase to diminish. In other words, take a hike, Mr. Pickens.

In the meantime, let’s take a close look at hybrid cars.            

Joe Brisben is a financial advisor at BDF Investments, Coralville, Iowa, a division of Broker Dealer Financial Services, member of FINRA and SIPC. Hear his commentaries at 11:50 a.m. weekdays on KCCK, 88.3 FM.

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