Politics & Policy

Got The Oil Jitters?

No worries. History is on your side.

There are two major factors impacting the stock market today: Iraq and oil prices. Both are of a temporary nature, and once resolved, the stock market will resume an upward path.

The primary reason for the resumption will be continued strong economic growth and supportive policies of fiscal stimulus. Fears of higher inflation and interest rates have triggered a sell-off in interest-sensitive securities, with intonations that interest rates are on their way back up adding to the selling pressure on these securities. But major increases in interest rates are unlikely, and a few insightful investment managers have already begun to take advantage of these fears.

On Iraq, the recent turmoil in that country is marking the end of the war, not a continuation of it. Once an Iraqi government is firmly in place, there should be a lessening of violence and improving standards of living for most Iraqis. Peace in Iraq will allow the U.S. to focus on the main culprit in global terrorism — the terrorists.

The oil-price question can be boiled down to this: Why haven’t we learned from past experience? The United States has experienced major surges in oil prices for political and economic reasons before, with the resultant innovation, substitution, and conservation producing a crash in oil prices. Note the following chart, which tracks the rise and fall of oil prices. Today, oil prices are above $40. This was the case in 1980 when forecasters called for $80 per barrel oil. The idea that oil at $50 to $60 a barrel is right around the corner is reminiscent of the errant forecasts of two decades ago.

In 1981 I was an associate with economist Art Laffer. Back then his firm produced a controversial report forecasting a dramatic decline in oil prices. Laffer’s firm recommended to Toyota Motor Company that they focus on producing the largest, most luxurious car they could produce and sell it in the United States. Their success was assured, especially since the Big Three auto makers were all rushing to produce the smallest, cheapest cars to maintain sales in an environment of perceived $80 per barrel oil. Toyota didn’t take that advice, but Honda did. They gained a four-year advantage over Toyota by bringing their luxury car, the Acura, to the U.S. market. This was one of many stories that could be told about companies succeeding or failing in the face of dramatic errors in the forecasting of oil prices.

While the deregulation of oil prices had a lot to do with the subsequent fall in the barrel price of oil in the 1980s, three other factors — innovation, conservation, and substitution — all played an important role in the price decline. Most analysts should be researching how these three powerful forces will impact oil this time around. At the same time they should determine what impact higher oil prices will have on supply.

One indicator of how higher oil prices impact the supply of oil is the actual effort being made by the oil industry to drill for oil. The following chart tracks the number of drilling rigs in operation at various levels of oil prices. Obviously, expensive oil will stay in the ground when low prices make that oil unprofitable. However, with the recent barrel price around $42, one could expect a surge in demand for drilling rigs and oil-service equipment.

As of May 2004, the operating number of rotary rigs was 1,162 — not much higher than the level in 1998.

The news media would have us believe that we are powerless in the face of the OPEC cartel to drive the price of oil lower. As was the case in 1981, the creativity of U.S. consumers — both individuals and corporations — will propel oil prices lower. Here are the steps:

Innovation, which includes the acceleration of the development of alternative fuel vehicles; identification and development of alternative sources of energy; technology use to reduce the costs of exploration and development; and approved development of new oil fields.

Conservation, which includes buying and driving smaller cars; using telecommunications to reduce travel; improved economy of mass-transit; and new electronic devices to reduce energy use.

Substitution, which includes shopping over the Internet rather than driving to the mall and the use of smaller, more efficient commercial aircraft.

If corporations and consumers take these steps, oil prices may go lower sooner rather than later. The downside is that any major decline in oil prices may postpone the development of alternative energy sources and ultimately increase our reliance on high-priced oil.

For individuals concerned with higher oil prices, history is on their side.

– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc.

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