Rising oil prices a blessing or a curse?

Investors' bullish sentiment towards oil could be self-defeating, driving prices so high that they squelch any nascent rebound in demand, and possibly apply brakes to economic recovery, says Sunil Kewalramani

OIL at $68 a barrel, as opposed to the high $30s we saw earlier in the year, is good if you are hoping for an economic rebound. It testifies that the world economy is not yet about to fall into a great depression. The rally in oil reflects a range of factors: a weakening dollar, fears of inflation, increased investor risk appetite and the appearance of 'green shoots'.
    Oil has rallied more over the past 75 trading days than it did at any time during its entire bubble run from 2001-2008. In fact, its current rally of 99% since the low of 12 February is nearly double the highest 75-day rally during the last oil bull run (from December 2001 to April 2002, oil rallied 55% over 75 days). Oil has also gone from $33.75 to $67.75 in just 75 trading days. During the 2001-08 oil bubble, it took 409 trading days to complete the same task from January 2004 to August 2005. While many investors are arguing that oil's rally is a good sign for the global economy and equity markets, let's hope it doesn't revert to the inimical $150.
    The credit crunch may have sparked the crisis. But it was arguably high oil prices that first pushed the world towards recession by helping to trigger the US slowdown in December 2007. By the same token, it is being explained the fall in oil prices has now helped the world economy back to its feet. Let us do the arithmetic.
    Last year, oil prices averaged $100 a barrel. As the world was then consuming some 88 million barrels of crude a day, that amounted to a total annualised cost of $3,200 billion (bn). The subsequent collapse in crude prices has cut this year's average by half, to $50, generating an annualised saving of $1,600 bn.
    Now, compare this to what governments have pledged to spend. Excluding bank bailouts, the IMF (International Monetary Fund) estimates the discretionary fiscal stimulus provided by G20 countries this year and next will total 2.7% of combined gross domestic product. As G20 output is about $45,000 bn, this is equivalent to $1,200 bn, or threequarters of the help that lower oil prices have provided in one year alone.
    Do oil and stocks trade hand-in-hand? In general, oil and stocks are believed to have an inverse relationship. Looking at data from 1970 through 2008, oil and stocks have a correlation coefficient of -0.11, a negligible correlation, smaller than anyone wants to think. R-squared, which shows the relative relatedness of the two variables is 0.01 — which means that you can blame only 1% of stocks' jumping around on oil price movements. From 1992 to early 1994, over 20% of the movement in stock prices could be attributed to oil.
    Unlike previous recessions, oil prices today are much more closely aligned with stock prices, as commodities have become a popular investment vehicle.
    lf you've been following the markets on a daily basis over the past few months, you must have noticed that oil and stocks have been trading hand in hand together. The accompanying chart highlights the price of oil and the S&P 500 so far in 2009. As shown, both are up big since the March lows.
    To quantify this trading relationship, we calculated the correlation between the daily percent change of oil and the S&P 500 on a 50-day rolling basis going back to 1986 (as far back as daily oil pricing goes). Prior to recently, the correlation between the two over any 50-trading day period had never gone above 0.50 (1 is perfectly correlated). Now, however, the correlation between their daily moves is at its highest level ever and approaching 0.60.
    TODAY, oil and petroleum products are responsible for only 2.5% of America's GDP. We are less dependent on energy than 15 or 20 years ago. In 1980, US energy intensity or total primary energy consumption per dollar of GDP, was 15,000 Btu per dollar. Now, it is below 10,000 Btu per dollar, as energy intensity has steadily dropped. Besides, in the US — still the world's largest consumer economy — two of the most important sectors, information technology and finance, are much less energy-intensive than the erstwhile manufacturing and agriculture.
    Technically, oil and stocks should be inversely correlated. But, as we have seen above, oil and the S&P 500 has become increasingly positively correlated over a period of time, indicating clearly that speculative traders have entered the oil market in a big way. Abdalla El-Badri, Opec's secretary general, warned recently that speculators are back to work.
    Oil outperforming oil stocks: While the price of oil has risen from the $30s to $68, oil stocks have not really rallied much. Such a dramatic outperformance of oil vis-à-vis oil stocks indicates that oil is probably factoring in a speculative element, and not just health of the economy as widely perceived.
    Fundamentals of oil remain weak: Developed country inventories, for example, cover 62.4 days of demand, one of their highest levels ever, and 14.7 % more than a year earlier. US stores of crude are 16.5% higher than a year ago, even though imports are down 6.6 %, based on a four-week average. The rising Chinese demand may have more to do with the Chinese government stockpiling oil than an increase in energy consumption.
    The IEA predicts oil consumption would drop by 2.6 million barrels a day which is apparently the steepest fall since 1982 and considers the present economic recovery as temporary in nature. The World Economic Situation and Prospects 2009 study brought out by the UN recently predicts that the global recession might continue beyond 2010.
    It now costs almost 60% more to fill a vehicle than it did at the end of 2008. That is probably enough to knock half a percentage point off consumption, at an annualised rate. With spare Opec capacity at 7.5 million barrels per day, there's absolutely no reason for such a hurried move in oil prices. Investors' bullish sentiment towards oil could be self-defeating, driving prices so high that they squelch any nascent rebound in demand (for every 10 cent rise in gas price, people can spend $40 million less a day on other things), and possibly apply brakes to economic recovery. The fundamentals indicate that we are likely to revisit the oil boom and bust scenario witnessed in 2008.
    (The author CEO, Global
    Capital Advisors)

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