Ramblings of a Portfolio Manager

Why isn’t Higher Oil the Straw in the Proverbial Camel’s Back of the Market?

After two weeks of turmoil in the Middle East and Africa, the major US equity averages have moved very little. Since riots in Egypt broke out at the end of January NYMEX crude has risen approximately $21/bbl, from roughly $85 to $106, a nearly 25% increase. Gasoline prices at the pump have risen a more modest 10%, yet despite the hike in real costs to consumers and the flood of negative press and television images, the Dow and S&P 500 have only declined by about 2% respectively from their highs. In fact, both indices are now trading exactly where they were at the end of January, when all this turmoil broke out in the first place. The spike in oil, naturally, has drawn pundits from out of the woodwork declaring potential economic Armageddon from higher oil, quoting such sensitivity numbers as a $2 per share impact in S&P earnings per every $20/bbl rise in oil. We don’t have the economic inputs for the model nor the Cray computer to run them to test this assertion so we’ll just take if for gospel (dangerous, we know). Based on current 2011 S&P earnings estimates of about $93 per share, that $2 would be roughly a 2.2% decline in corporate earnings for this year. Assuming no multiple contraction, that would equate to about 29 S&P or 270 Dow points, which would put us back just to where the markets were at the end of January, when all this began--that just so happens to be where we are right now!. Of course, with decline corporate earnings, one would expect some multiple compression resulting from the attendant dampening of investor sentiment. At the current multiple of the S&P 500, 14.2, a full multiple point of compression (pretty high historically) would equate to another 7% decline in the index. Combined with the prognosticated reduced corporate earnings power, that would give us the 10% decline that “everyone” is expecting as a pullback. A decline of that magnitude would just bring us back to about December 1st in the S&P 500.

But the tradeoff between oil prices, GDP and stock market levels is not rigidly formulaic. There are a number of variables that impact market levels in a rising energy market and make for a dynamic situation that, in reality, no economist or oil company executive (let alone a politician) can predict. For example, investor sentiment, which at the beginning of February was at a level that just about every talking head on TV who could emerge from under a rock proclaimed signaled a market pullback, has dropped significantly. According to AAII, the percentage of investors who are now bullish is nearly equal to those that are bearish at 36% vs. 32%. This is down from a level of nearly 52% bullishness at the beginning of February, just as the oil region turmoil began. The contrarian in us likes this move, especially in light of the relatively small decline in market averages.

Another factor that goes into the GDP vs. market level vs. energy price tradeoff is the impact at the consumer level, something the TV pundits like to take throw out continually. Here, simple math that even we can do throws this argument into doubt. According to the NHTSA, the average American drives 15,000 miles per year. According to the DOT, the average fuel consumption of all cars, light trucks and SUVs on the road today is 21.4 miles per gallon. Since the rioting began, gasoline at the pump is up, on average, about $0.33/ per gallon. Simple math tells us that the impact per average driver would be about $231 per year IF these higher gas prices persist for another year or more. Now, $231 may not seem like a lot to Wall Street types but it can be meaningful to the average American, at the margin. However, taking an adage from Wall Street, “nothing cures high oil prices like high oil prices.” That means, in basic economic terms, as gasoline prices climb, demand, being elastic, declines, thus reducing the per-family dollar impact and, eventually, bringing down the price of the commodity. The latest data we have on this phenomenon is from March 2008, when gas prices reached highs we are currently seeing at the pump. At that time, the number of miles driven dropped 4.3% in response, according to the Federal Highway Administration. Right now, even though oil has jumped 25%, stockpiles (you’ve heard all about Cushing and the spare oil sitting around in tankers in harbors around the world) have kept the pump price impact to half of that and will probably do so for several months. And that pump price needs to stay here for another 12 months before we see any significant impact to the average driver. At that point, miles driven will most likely decline, negating some of the impact. But we have a long time for stockpiles to be reduced (remember, ONLY 1.8% of the world’s supply has been cut and that has only seen a 50% reduction). In the meantime a situation such as we saw in 2007 and 2008, a significant move to more online shopping, will further negate the impact to consumers and consumer-related companies.

Of course, the GDP impact of higher oil isn’t just dependent upon consumers’ driving and spending habits. Energy is also used for home heating and transportation of goods, in addition to manufacturing (think plastics). On the first point, the Northern Hemisphere is now entering Spring/Summer. Heating demands will plummet, lessening both demand and the impact to consumer wallets. Transportation (trucking, rails, airlines, etc.) has gotten much more efficient over the last decade, further lessening the impact to the economy versus prior oil shocks. Our manufacturing economy has become both more efficient in energy use but has also transformed over the years. In fact, the dollar output of GDP per unit (BTU) of energy consumption has almost halved since 2000, according to the US Census Bureau. Simply put, our economy, despite all the hand wringing by opposing political parties, has indeed become less energy dependent as it has transformed from manufacturing to high-tech and financial services. Another 70’s style oil shock may well have a GDP impact but it can be expected to be much, much less in terms of reduction of domestic output.

The quoted $2/share S&P earnings impact per $20/bbl in oil presumes a permanent upward spike in oil to that higher level. So far, we have had only two weeks of rising oil and the new, higher price has not arrived all at once—it has been a steady incline. Except for airlines and other energy sensitive transportation industries, few US companies have yet felt the bit of higher oil. And, unless this new level of crude remains permanent or rises further, we believe few will. Right now a 25% rise in oil based on a 0.9% decline in supply says to us that there is a big “contagion premium” built into in oil prices right now. That premium probably assumes several Middle East countries undergo what Libya is now seeing, but probably not Saudi Arabia. A lot needs to go wrong in the Middle East for that scenario to develop—a fairly low probability, in our opinion. One thing we have to stress, though, is that all this turmoil represents a disruption, not destruction in supply. The length of this disruption is anybody’s guess but you can be sure that, as economies wholly dependent upon selling the black sticky stuff, the oil producing nations will ensure that it is as short as possible—or their troubles will only compound. That says to us that the price of oil has most likely over-reacted to current world events and that the equity markets have reacted rationally. Now that investor sentiment is low and oil is high, when we get a reversal of both (which we will and they will come together) the base will be set for much higher equity markets.