Will Rising Oil Prices Kill the Economic Recovery?

by Matthew Weinschenk

Will Rising Oil Prices Kill the Economic Recovery?

by Matthew Weinschenk, Contributing Editor

Thursday, April 22, 2010: Issue #1244

"Oil Could Give Kiss of Death to Recovery."

So blares a recent headline in the Financial Times, which highlights the fear that higher oil prices will trigger a double-dip recession.

But what a difference 12 months makes. Barely a year ago, economic savants were busy claiming that the economy couldn't experience a recovery, due to falling oil prices.

So do we want high oil prices or low oil prices? Both have their pros and cons...

High Oil Prices Have Preceded Prior Recessions... Will History Repeat With $100 Oil Looming?

When oil demand and consumption are high, it's a sign that the economy is vibrant. This drives up oil prices.

But if prices rise too high, or too fast, it puts pressure on consumers and can choke off spending. And we've seen the kind of serious damage that this has done before - 10 of the past 11 recessions occurred after a rise in oil prices.

This chart illustrates the effect of rising oil prices on the economy. The gray shaded areas represent various recessions.

Rising Oil Prices and Recession

To see the chart in it's original size, click here.

So where are we today?

Over the last 12 months, oil prices have risen over 55%. And the price of gasoline has followed, with the nationwide average price per gallon jumping from $2 to $2.88.

Looking forward, most investment houses see the price of oil hitting $100 per barrel within the year. That includes our own energy and infrastructure expert, David Fessler, who says oil prices have nowhere to go but up.

So the question now is... will today's high oil prices kill our freshly sparked recovery?

Three Reasons Why Rising Oil Prices Won't Harm the Recovery

The risk to the economy of rising oil prices comes from a threat to consumers' budgets and confidence. Simply put, when consumers spend more on gas it drains resources from the rest of the economy.

That said, there are three reasons why oil prices can't derail this recovery...

Reason #1: Oil Prices Haven't Risen Enough to Upset Consumers

Right now, Americans buy over eight billion gallons of gasoline a month for motor vehicle consumption. So considering that gasoline prices are up almost $1 a gallon over the past year, that draws $8 billion out of consumers' pockets.

However, disposable income for the fourth quarter of 2009 topped $11 trillion, so don't expect a $1 change in gas prices to do much.

Based on the last go 'round, drivers didn't cut consumption until prices topped $3 a gallon, so we've still got some wiggle room.

United States Gasoline Consumption

To see the chart in it's original size, click here.

And that brings me to the second reason...

Reason #2: Consumers Will React Differently This Time

When oil and gasoline prices jumped in 2008, the speed of the increases was a major shock to consumers.

Today's rise, however, is slow and steady. And as a result, consumers have had more time to change their behavior to combat the higher prices - whether it's buying a more fuel-efficient car, commuting by mass transit, or simply budgeting for higher fuel costs.

More importantly, after the previous surge in oil and gas prices, consumers are more prepared for oil market volatility these days. If possible, they should have tried to clear some extra room in their budgets and we shouldn't see the same level of panic that we saw in 2008.

I'd expect demand erosion to start closer to $3.50, rather than the $3 we saw last time.

Reason #3: Consumers Haven't Changed Their Behavior Yet

Here's a key indicator to watch in the oil/gasoline price-consumer behavior equation...

Vehicle miles traveled.

Unless this number drops sharply and teases the -5% level, we shouldn't have to worry too much about oil prices putting the brakes on the economic recovery.

United States Vehicle Miles - Oil Price-Consumer Behavior Equation

To see the chart in it's original size, click here.

Big Oil is Eyeing Big Money... Here's How to Claim Your Share, Too

So aside from staying invested in the general stock market, how can we profit from this information?

In short, it adds up to a rare opportunity for oil companies. With oil prices rising and consumers already expecting to spend more, it's a virtual license for oil firms to print money (not that oil companies have struggled over the last few decades).

On top of that, my cyclical models suggest that energy stocks as a whole are poised to outperform the market.

Energy Stocks Poised to Outperform the Market

To see the chart in it's original size, click here.

The best plays here would be to invest in major diversified oil companies and oil field servicers.

Two quality stocks to add to your portfolio would be Exxon Mobil (NYSE: XOM) and Schlumberger (NYSE: SLB).

But if you want the chance to grab bigger gains among smaller oil companies, consider Lufkin Industries (Nasdaq: LUFK). With a market cap of just $1.2 billion (versus $325.3 billion for Exxon Mobil and $81.5 billion for Schlumberger), Lufkin provides oil field pumping units and other supplies and has notched a double-digit sales growth rate per year over the past five years. The company also just beat its quarterly earnings estimate.

In conclusion, don't worry about high oil prices crimping the economic recovery... at least not right now. Rest assured, though, we'll keep you posted on the action to take if that changes.

Best regards,

Matthew Weinschenk

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