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Economics: Oil and the Economy
New York: August 22, 2005
By John R. Stephenson

Oil continues to confound the experts. In spite of high oil prices, the global economy keeps chugging along and consumers keep on shopping with little regard for higher prices at the pump. Recent reports by the International Energy Agency have predicted that oil would have to reach $80 per barrel to have any significant impact on consumer behavior. Recent U.S. numbers seem to bear that out. The latest retail consumption growth in the U.S. hit a high water mark this past quarter posting a 5.5% gain in real consumption. So far, oil prices at forty, fifty and sixty dollars seem to have no affect on the U.S. consumer - but for how long?

Rising oil prices have been associated with nine out of the last ten recessions, but so far, things seem to be moving forward without a hitch. As our efficiency has grown, expenditures on oil and gas as a percentage of total spending have come down to the point now where oil usage, as a percent of GDP, is less than half of what it was thirty years ago. But even so, economists figure that rising oil prices still have a detrimental affect on consumer spending with a $10 rise in oil resulting in a loss of about 0.4% of GDP. Yet, according to the latest consumption figures, we continue to spend - and at record levels.

Figure 1: Oil Prices Continue to Surge

Source: PC Quote

But there are signs that rising oil prices are starting to have a detrimental affect on the economy. In the past few weeks, Wal-Mart announced that future sales are likely to be softer as a result of higher gasoline prices which makes it more expensive for customers to travel to Wal-Mart to shop. For many people at the lower-end of the wage spectrum, rising gas prices can make the difference between living comfortably and scrimping by.

As oil soars to $2.70 a gallon and beyond at the pump, it starts to become a bigger and bigger issue for the average consumer. With vehicle miles driven increasing at roughly 3% a year and with SUV's representing 54 % of all vehicles sold, can it be long before sustained higher gas prices start to take their toll? In inflation adjusted terms, the price of oil is now some 25% above the levels reached at the start of the first Gulf War (late 1990) when oil prices last surged. But the real story is the strong 40% surge in prices over the last six months which have taken real (inflation adjusted) oil prices up threefold since the trough of the recession of 2001.

While the economy continues to confound, one fact is inescapable. Higher oil prices will eventually start to take their toll and this time, the consumer is poorly prepared for sustained higher prices. While consumption growth chocked up a record 5.5% gain in the quarter, another record was also recorded - a 0% personal savings rate. This contrasts with the oil shocks of the 1970s where the personal savings rate averaged 9.5%. Today's "zero" saving rate underscores a key vulnerability for the American economy - there is no cushion or margin for error if the consumer starts to stumble. The only backstop that exists for overburdened consumers is the inflated value of their homes making rising oil prices the weakest link in an increasingly fragile economic recovery.

With American consumers saving little to nothing, the economy is more reliant than ever upon borrowed savings from abroad to fund domestic economic growth. Much of that borrowing has come from China and the rest of Asia. But to attract this capital, the U.S. has entered into a dangerous game of ever increasing current-account (exports less imports) and trade deficits. In the month of June, the U.S. witnessed a record trade gap of $59 billion (the third largest on record) which only serves to underscore the magnitude of the deficit problem. Rising trade deficits only heighten the possibility that eventually foreigners will refuse to accept an ever increasing amount of our securities (Treasury bills) which will drive rates sharply higher in an effort to keep and to find new lenders.

Another possible cloud on the horizon could be a slowing Chinese economy. With less money to invest in our government bonds, rates might have to rise sharply to induce the Chinese and others to hold our securities. With consumers wedded to the mantra of ever rising house prices, a "zero" personal savings rate, rising oil prices and debt ratios that are in nosebleed territory, the U.S. economy is dancing on the head of a pin.

Investors who wish to benefit from rising energy prices should consider investing in exchange traded funds ("ETFs") that offer the benefits of a mutual fund (diversification) at a much lower cost. To buy a diversified basket of energy companies, investors could consider buying "XLE" an energy sector ETF which offers a diversified basket of energy names. As well, a falling U.S. dollar is generally a good thing for the price of gold. Investors who think the dollar has topped out should consider the GLD a gold ETF that gives investors the benefits of rising gold prices without the disadvantages of physical storage.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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