Rising Oil Prices
The looming price boards at gas stations across the U.S. reflect spiking gas prices at the pump and in global markets, a haunting reminder of the 2008 credit crisis. Prices have not been this high since the summer of 2008, when the national average for a gallon of gas exceeded $4. While the economic collapse of late 2008 was mostly the result of the bursting housing bubble and the subsequent downfall in valuations and liquidity in the banking industry, rising energy prices certainly contributed to overall volatility. Indeed, spikes in energy prices have contributed to every recession of the last 40 years.
The chart below shows the historical price of West Texas Intermediate (WTI) crude oil going back to 1973. This chart is drawn on a logarithmic scale, where each horizontal line indicates a doubling of the price of crude oil. Each shaded area on the chart reflects a period of recession in the U.S. If we consider the double-dip recession of 1980 to 1982 as one large contraction, each of the recessions over the last 40 years coincided with or–more accurately–was preceded by a spike in oil, where prices doubled over a short period of time.
As of mid-March, the national average price for a gallon of gasoline was $3.58. While this is more than enough to affect the average Americanâ€™s wallet, it is off the highs of last May and the record high of $4.06 per gallon in July 2008. Itâ€™s important to note the time of year that prices have hit their prior highs. In 2008 and 2011, the price of gas peaked in July and May, respectively. The price of gas has never been higher in March as gas prices typically rise by an average of 8% from the end of March through the end of July. Based on todayâ€™s price, an â€œaverageâ€ increase in the price of gas would result in a new record high of $4.13 per gallon by the end of July.
The squeeze that Americans are feeling from higher gas prices is due to the rising price of oil as well as an anomaly in the relationship between the U.S. crude oil benchmark (WTI) and the international benchmark (Brent North Sea).
Historically, the two benchmarks have traded in sync with each other, with WTI crude often trading at a premium to Brent. That longstanding relationship began to break down in 2011 as the price of Brent crude relative to WTI soared. By the end of last summer, the spread between the two benchmarks widened to a record of $28. While the spread contracted toward the end of 2011, it remained elevated and has since started widening again to a current level of $18.40.
So why does this spread matter? Unfortunately for American consumers, the price of gasoline is more closely tied to the price of Brent crude oil rather than WTI. The charts below illustrate this by comparing the price of unleaded gasoline to the price of WTI (left) and Brent (right) crude oil. Since the start of 2011, the price of WTI oil has risen 17%, while the price of gasoline has rallied 36%. At first glance, something in addition to the price of oil seems to be driving gas prices. However, in the chart on the right, which compares the price of gasoline to the price of Brent crude oil, the two series practically overlap. Since the start of 2011, Brent crude has risen 33%, while gasoline has risen 36%.
With oil and gasoline prices already high and likely to go higher, it seems like an economic soft patch or even a recession is a foregone conclusion. There is no doubt that consumers are already facing a tighter squeeze on their income from rising oil and gasoline prices, but there are a number of other factors that suggest that this time around will be less onerous. These factors include the effect of weather, the prices of other energy alternatives, increased fuel efficiency, and the evolving makeup and recovery of the U.S. economy.
The general lack of cold weather in the U.S. this winter has helped to ease the pressure of higher oil prices. For the lower 48 states, the winter of 2012 ranks as the fourth warmest on record, according to the National Oceanic and Atmospheric Administration (NOAA). With the exception of certain regions of the western U.S., temperatures were higher than normal across the country, and temperatures ranked among the 10 warmest on record for 27 states. As a result, heating bills were lower for most Americans despite high heating oil prices due to lower demand.
At the same time that higher oil prices have dragged on the U.S. economy, the price of natural gas has been providing a boost. Although WTI and Brent crude oil prices are both higher since the start of 2011, the price of natural gas has plummeted. Natural gas doesnâ€™t get nearly the same attention as crude oil, but it currently accounts for about 25% of U.S. energy consumption, and that share is growing, according to the U.S. Geological Survey.
Historically, oil and natural gas prices have traded in a welldefined range. However, with numerous discoveries of natural gas in the U.S. over the last decade and new methods for extraction, supplies have mushroomed. As a result, prices of natural gas have dropped by 47% since the start of 2011. Over a longer-term time period, the drop has been even more pronounced. Since hitting a peak of $15.78 MMBtu in December 2005, the price of natural gas has dropped 85%.
Refocusing on oil and its role in the U.S. economy, a lot has changed over the last 60 years. At the end of WWII, the U.S. economy remained heavily dependent on oil. From 1949 through the late 1970s, the ratio of GDP to oil consumption was relatively constant, hovering between $775 and $877 of real GDP for every barrel of oil consumed.
Following the oil shocks of the 1970s, however, two trends helped to make the U.S. less leveraged to the price of oil. First, the U.S. took steps such as increasing efficiency standards to make the economy less reliant on oil. More importantly, the high tech boom of the 1980s and 1990s helped to increase efficiency within the U.S. economy and enabled companies to outsource energy-intensive manufacturing processes to other countries and focus more on less energy-intensive services. In 1979, the U.S. economy produced $866 of real GDP per barrel of oil consumed. By 2009, real GDP per barrel of oil consumed in the U.S. had more than doubled to $1,852!
The fact that the U.S. economy is less reliant on oil provides little comfort to consumers watching helplessly as gas prices take a larger bite from their monthly income. The reality, though, is that while the national average for a gallon of gas is 7.5% off the record high from July 2008, the percentage of income that Americans are currently spending on gas (5.1%) remains 18% lower than its peak of 6.3%.
The reason for this disparity is that since gas prices peaked four years ago, average incomes have increased by 9.2%, and average fuel efficiency has improved 6.2%. The chart to the right shows the percentage of average monthly income it takes to drive an average car 1,000 miles and is a measurement that accounts for average income, gas prices, and fuel efficiency. Adjusting for changes in all three variables means that in order for the share of total income that goes to gas to reach its prior record, the national average price of gasoline would have to rise 23% to $4.71.
Going forward, increased fuel efficiency of cars on the road will partially offset rising gasoline prices. In 1975, the average car on the road got 13.5 miles per gallon (mpg), while the average truck got a mere 11.6 mpg. With the oil shocks of the 1970s still fresh in the mind of the American consumer, carmakers took steps to increase efficiency.
Over the next 13 years, fuel efficiency for cars increased 79% to 24.1 mpg, while efficiency for trucks increased by 54% to 17.9 mpg. By the mid to late 1980s, though, the price of oil was trading in the low teens, and Americans were no longer concerned with fuel economy. Over the next 20 years, fuel economy in the U.S. declined modestly, and oil fuel efficiency did not again have a meaningful uptick until 2007, when oil was near $100.
Not only are Americans getting better gas mileage when they drive, but they are also driving less. From 1971 through 2007, the total number of highway miles driven in the U.S. increased annually by 2.74% and declined in only three years. In the four years since 2007, though, miles driven have decreased cumulatively by 2.25%.
As the U.S. economy has changed over the last several years, it has gradually become able to withstand moves in the energy markets that in the past would have almost certainly caused a recession. The gradual increase in oil prices that we have seen since the recession that ended in the middle of 2009 is not enough to tip the economy back into recession, in our opinion. Nevertheless, any rapid spike in the price of crude arising from a conflict in the Middle East could be more than our economy can currently handle.
As usual, we are only a phone call away should you wish to discuss any of these issues relative to the financial planning and investment goals you have in place.
This market commentary is an advertisement and was written and produced by Michael W. Conway of Summit Financial Resources, Inc., 4 Campus Drive, Parsippany, NJ 07054. Tel: 973-285-3600, Fax: 973-285-3666 with assistance from Bespoke Investment Group, LLC. Indices are unmanaged and cannot be invested into directly. The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity. Standard & Poorâ€™s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. Past performance does not guarantee future results. Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding markets or other financial information, are obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader. Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance. Consult your financial professional before making any investment decision.