Monday, March 7, 2011

Rising Oil Prices Do Matter

Most Americans have likely noticed the recent sharp rise in gasoline prices. The nationwide average has recently surged above $3.50 per gallon, which is a more than 20% rise in the past month. Crude oil has also spiked higher during the past several weeks, going from the mid-$80's to over $105 per barrel. Recent tensions in the Middle East and, most notably, decreased output from Libya have been the primary drivers behind the soaring prices. A revolution in Bahrain threatens to spread into Saudi Arabia, with potentially drastic consequences for the global supply of oil. Rising prices in oil have begun to affect other asset classes throughout the world and volatility has risen significantly.

Despite the rise in oil prices over the past several weeks, U.S. equity markets remain only a few percent off recent multi-year highs. While several investors, including David Rosenberg, have pointed out the historical correlation between oil prices at this level and forthcoming recessions, many of the large investment banks and media have sought to downplay the effects of higher oil prices. The most common argument against any effect of rising oil prices on consumer spending is fairly simple: Americans have become more used to higher oil prices over the past couple years, making any adjustment in consumption habits less likely. At firth glance, this notion seems reasonable enough. However, upon taking a closer look this concept appears not only faulty but in stark contrast to principles assumed in other markets. 

First, let's consider the basic idea that higher oil/gasoline prices won't lead to reduced personal consumption. In any given month, most consumers income is fairly well known in advance. Typical consumers have a number of core goods they purchase (food, rent/mortgage, transportation) and money left over for discretionary purchases or saving. If the price of gasoline rises 25% and consumption is unaffected, then total spending on gasoline has to increase. For consumer spending on all other items to remain unaffected, Americans must either reduce savings, increase debt or reduce consumption of other goods. Given recent history, expecting consumers to reduce savings or increase debt is certainly not unreasonable, although those practices have generally proved unsustainable. 

The other issue with the argument for disregarding higher oil prices relates to the typical comments made about equity markets by the same firms and media. Over the last decade, U.S. stock markets have experienced two declines of greater than 50% and ultimately ended the decade with zero gains. Although recent history has been poor for equity investors, most analysts today suggest investors ignore recent history and focus on the long-term average gains for U.S. stocks. The Federal Reserve has even been forward in stating that QEII was in part meant to lift assets prices above normal levels, inducing further spending. However, if the principle for oil that rising prices don't affect consumption holds, one has to wonder why rising stock values would trigger increased consumption. Anyone who looks at the price movement in oil and stocks over the past 5 years will notice a strong resemblance. While I can't say definitively whether these price changes will effect consumer choices, it's hard to understand how many proponents of efficient markets could argue for the irrationality of consumers responding in opposite ways to similar effects. 

An entirely separate but nonetheless disturbing argument for the non-effect of rising gas prices on consumption relates to Americans taking public transportation. The basic argument suggests that Americans using public transportation are now saving significantly more money than before. On a fundamental level, savings equals income less expenditures. For a current rider of public transportation, any rise in gas prices that does not affect tolls, will fail to have any effect on the consumer's income or expenses and therefore savings remain unchanged. Although the consumer may experience savings in terms of opportunity cost, the idea that the consumer could use the extra savings to increase spending is off base. 
[Personal anecdote: My freshman roommate in college once told a story about his Dad's trip to Vegas. The father, who was not a big gambler, would decide before the trip that he was willing to lose $1000 gambling. During the trip, the father lost approximately $500. However, when asked how he'd done gambling in Vegas, the father would respond that he won $500. In his eyes, since he'd expected to lose $1000, the fact he only lost $500 was equivalent to winning $500. Regardless of this view, the father did not have $500 more than when he started. In fact, he had $500 less and therefore could not increase spending without adjusting savings, debt or other consumption.]

It's unclear where oil prices will go from here, although tensions in the Middle East should be expected to continue for an extended period of time. The potential for increased fear and speculation to drive prices higher should not be ignored. The concept that a specific level exists at which point global growth will suddenly face significant headwinds seems unlikely. If personal consumption in the U.S. is effected by higher gas prices, downward revisions to future GDP growth may be coming. Given current valuations, caution remains the best investment principle for the time being.