$150 Oil. It could be worse.

John Osbon - July 6, 2011

A lengthy Barron’s article by Gene Epstein over the weekend calls for $150/barrel oil in the next 12 months.  As one of the 8 most important prices in the world, the tab for oil can have a profound impact on business performance, economic growth, and the risk and return of investment portfolios.   So what happens if the Barron’s prediction is correct?  Should you make changes in your portfolio based on the possibility?

How bad is it?

An oil shock of $150, or even $170, coming in next year, translates to $4.50/gallon gas, according to Epstein.  He suggests that additional cost for gasoline would mean less money for consumer spending elsewhere, knocking more than 1% off the growth of GDP in the US in 2012.  Gas at that price sounds nasty, but the rest of the world has already been living with much higher pump prices ($8 in London, $7 in Tokyo, $9 in Munich) due to much higher government taxes on gasoline.

Facing these much higher prices, Europeans and Asians have learned to conserve, and somehow manage the drive to work without the protection of a three ton SUV.

This chart shows gas prices (dollars per gallon) in red and total taxes in blue, May 2011. Source: The Atlantic

Not so fast

If this price rise is coming, maybe everyone should go buy oil. Or maybe not. First of all, you can’t invest in oil.  You can’t own it directly, unless you are willing to rent a tanker and store the crude itself.  Yes, there are ETFs that purport to replicate oil ownership (here’s a list), but their ability to track the actual price of crude is highly unimpressive.  The reason has to do with the term structure of oil futures prices, and the market phenomena of contango and backwardization.

So, investors intent on timing the oil market are left with the choice between owning securities that are heavily influenced by the price of oil – IXC, the global oil stock ETF, or the stock of Exxon Mobil, or other oil industry securities – or braving the perils of the futures market (where few individual investors should ever wander, I believe).

We suggest neither.

In my view, individual investors should hold highly diversified portfolios that include a small allocation to energy related securities. But trying to decide when to buy and sell based on the guesstimated future price of a commodity influenced by fickle forces like politics, weather and despots, well, that’s not a game worth playing, in my view.

What now?

In the end, oil prices may simply be less important to your portfolio than in the past.  Why?  There are two possible reasons, neatly noted by Epstein.  First, in a service economy like the US (80% of GDP), the price of oil matters less.  Second, we are more efficient.  In the US, spending on crude peaked at 9% of GDP in the ‘80s.  Now, it is in a range of 4-7%.

Noisy headlines like “$150 Oil!!” may sound ominous, but a diversified portfolio should be able to benefit from, as well as withstand, higher oil prices.

 

 

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