Don’t Get Caught Up in Fuel-Price Panic

by Dan Burrows | March 8, 2012 12:09 pm

For 40 years now, there’s been nothing quite like an oil-price shock to spook equity markets. Sharp spikes in energy expenses play havoc with personal spending and corporate costs alike, all to the detriment of economic growth and share prices.

That’s why the crisis with Iran has pushed the European debt drama aside as perhaps the market’s main worry these days. Benchmark crude oil futures are flirting with $110 per barrel in New York trading, while gas already is above $4 per gallon in a number of states. And that’s before the summer driving season has even begun. Indeed, national average retail gasoline prices rose 50 cents to $3.78 as of Feb. 27, according to the U.S. Department of Energy, up from $3.29 in mid-December. They’re expected to climb even farther[1] in the months ahead as Americans hit the road for summer fun.

But fears that skyrocketing energy prices will derail the economy and market rally appear to be overblown thus far, analysts say. True, should prices spike significantly higher, all bets are off, they say. But Americans are much better able to deal with higher oil and gas prices now than they have been in many years.

For one thing, folks have been paring debt — or deleveraging — for three years now, notes Tom Sowanick, chief investment officer at OmniVest Group. That means they have more income to devote to higher gas prices. Furthermore, natural gas prices are at a 10-year low and a mild winter saved plenty of consumers a bundle on their heating bills.

Additionally, prices could be set to reverse themselves before too long. Jeffrey Kleintop, chief market strategist at LPL Financial, notes that oil prices are tracking a similar trading pattern to last year’s rise during the Arab Spring. Yes, prices peaked in late April at $114 per barrel in New York trading, the stock market sold off after a strong start to 2011 — and ultimately ended the year at breakeven on a price basis.

But last year, stocks were undone by more than high energy prices. The market actually recovered once energy costs eased. What really doomed stocks last year was sluggish domestic growth, the earthquake and tsunami in Japan (at that time the world’s third-biggest economy after the European Union and the U.S.) and rising anxiety over the European debt crisis.

“The move higher in oil prices so far this year is similar in pattern to last year’s surge, but the story is a bit different this time,” Kleintop says in a new note to clients. “The combination of rising prices sapping consumer spending power and the deteriorating earnings outlook paint a negative picture for the markets. However, with prices already high, a resolution to geopolitical talks or added supply from other sources may provide some relief.”

And any resolution to the tension with Iran would likely provide quick relief in short order, as oil supplies are currently well above average. How the tensions between Iran and Israel resolve themselves is anybody’s guess, but one consolation as the tensions escalate is that oil supplies are way above average, notes Bespoke Investment Group.

At a current level of 345.7 million barrels, crude oil stockpiles are 6% above their historical average since 1984 and more than 8% above their average levels over the last 10 years, according to Bespoke. Moreover, there have only been six years since 1984 where oil inventories were higher than they are now.

“An escalation of tensions in Iran would no doubt boost oil prices, but at least the market is relatively well prepared,” Bespoke notes.

Finally, the last condition militating against oil and gas prices acting as a drag on the economy and consumer spending is that we’ve seen these levels before, notes James Hamilton, professor of economics at University of California, San Diego.

“Although the prices of oil and gasoline have risen significantly from their values in October, they are still not back to the levels we saw last spring or in the summer of 2008,” Hamilton writes.

That’s critical, because the statistical evidence shows that an increase in oil prices that does no more than reverse an earlier decline has a much more limited effect on the economy than if prices surge to a real new all-time high.

“One reason for this is that much of the impact on the economy of an increase in oil prices comes from abrupt changes in the patterns of consumer spending,” Hamilton says. “But if consumers have recently seen even higher prices than they’re paying at the moment, their spending plans and firms’ production plans are likely already to have incorporated that reality.”

Should prices spike to worst-case scenario levels — anywhere from $130 to $270 per barrel for Brent crude, according to UBS — well, then look out below. But we’re nowhere near those levels yet. And if last year’s trading pattern is any guide, oil prices are close to their ceiling — and likely to reverse course before too long.

  1. expected to climb even farther:

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