Dispelling Some Crude Myths About Oil’s Real Impact

by | Aug 10, 2004

Economists are beginning to panic about the recent run-up in the oil price (+36%, year to-date, to $44.4/barrel) and its likely future impact on stock prices, profits and output in the U.S. But there’s no reason to panic. A fast-rising oil price is no necessary impediment to forthcoming growth. Other negative factors are required. In […]

Economists are beginning to panic about the recent run-up in the oil price (+36%, year to-date, to $44.4/barrel) and its likely future impact on stock prices, profits and output in the U.S. But there’s no reason to panic. A fast-rising oil price is no necessary impediment to forthcoming growth. Other negative factors are required. In the absence of such factors — like another terrorist attack in the U.S. — the oil price over the coming year is more likely to drop to $30/barrel than it is to spike above $50/barrel. But even if oil does rise further, it isn’t likely to sabotage the coming bull market.

Economists are panicking about oil because they’ve been schooled (a.k.a., brainwashed) to believe a fast-rising oil price (and Mid-East sheiks) caused the “stagflation” and severe bear markets of 1973-75 and 1979-1980. They fear such sorry results will recur in the wake of the latest oil-price rise. In fact, however, the 1970s stagflation was caused by President Nixon’s devaluation and sabotage of the U.S. gold dollar in 1971 and by the subsequent interaction between rising inflation rates and high/graduated tax rates (“bracket creep”). In the 1970s Washington taxed real incomes in America at confiscatory rates and through its inflation boosted both short and long-term interest rates to punitive, double-digit levels. Despite the dollar’s depreciation since 2002, interest rates today remain in the low single-digits.

The oil-price rise in the 1970s (from roughly $4/barrel to $40/barrel) was the effect, not the cause, of Nixon’s hyper-inflation. Obviously, after the 1971 devaluation it took more dollars to buy a barrel of oil (and other goods), since each dollar became worth much less. But in real terms since then OPEC has received no additional, real value per barrel of oil than it did before the devaluation. Since 1971 both gold and oil have increased in price (in terms of dollars) by roughly ten times. But in terms of real value (gold) that means a barrel of oil today costs just as much as it did before the dollar’s devaluation; oil sellers today get just as much — and no more — real value per barrel of oil as they did decades ago.

In recent decades governments have done all they can to boost the oil price, primarily by issuing ever-more and less-valuable paper money, the monopoly money we’re compelled to use when buying oil (and other things). Oil is priced globally in U.S. dollars, so the issuer of dollars (Washington) is to blame for the fact that over time successively more dollars have been required to buy a barrel of oil. There’s been no lesser output or supply of oil itself (nor fewer oil reserves) compared to decades (or even a year) ago; but amid more oil supply Washington has created a still-greater supply of paper dollars. As under Nixon, a depreciating dollar brings a rising oil price. Since early 2002 a weaker dollar has been precisely the policy sought by the Bush Administration. No one should be surprised to see a rising oil price in the wake of such a policy.

The Bush Administration’s foreign-military policy also has propelled oil higher this year. Washington has botched the job in Iraq by refusing to transfer local oil fields to honest and capable Western hands. As elsewhere in the Middle East, the Iraqi oil fields were discovered and developed by Western oil firms (in the 1960s and afterward) but were subsequently stolen (“nationalized”) by Arab tyrants. Instead of returning oil assets to their rightful (and productive) owners, the Bush Administration has stood by idly amid a near-daily sabotage of Iraqi oil assets by local terrorists whom it refuses to maim or kill. The Administration also has periodically raised its so-called “terror alert” (as it did on August 1st), which only reminds market-makers that terrorist attacks in the U.S. remain likely and that Washington is still not performing its main job (national security). A similar message was sent in the recent report of the “9/11 Commission.” Meanwhile the GOP-controlled Congress has refused to enact an energy bill to permit more oil drilling on U.S. government lands in Alaska; at the same time it has hindered development of alternatives to oil by continuing to appease environmental terrorists whose obstructionism has prevented the building of any new nuclear power plants or transmission facilities in the U.S. over the past quarter-century. Price always rises when supply growth is curbed.

Oil’s price also has been further elevated this year by the Russian government’s terrorizing of a major, local oil firm and exporter. Last October Vladimir Putin, acting like the KGB thug he once was, jailed without cause the CEO of Russia’s second-largest oil firm (Yukos). Now Putin demands payment of $3.4 billion in “back-taxes” (extortion) from Yukos, while at the same time freezing and seizing the bank accounts, assets and personnel Yukos needs to pump more oil and earn more income. In seeking his $3.4 billion Putin has destroyed $23 billion of Yukos’ market value (75% of its prior peak). Beyond Russia, observe how other foreign governments (Norway) have raised the oil price by condoning strikes by oil workers and then forcibly preventing the replacement of strikers by willing workers.

These problems aside, the fact remains that oil-price spikes historically have preceded above-average gains in stock prices, profits and output. On average over the past three decades in the U.S. the S&P 500 price index has risen 9.4% per annum, while S&P 500 profits have increased 7.0% per year and U.S. industrial output has advanced 2.8% per year. But consider the gains registered in the aftermath of the ten worst oil-price spikes since 1971 — spikes which exceeded 20% over one-year periods and averaged an astounding 80%. In the one-year periods following these oil-price spikes the S&P 500 price index increased by an average of 9.6% — a rate above its long-term average gain of 9.4%; S&P 500 profits increased by an average of 7.6% — also above their long-term average gain of 7.0%; and U.S. industrial production index increased on average by 3.0% in the aftermath of severe oil-price spikes — yet again, an average annual growth rate that was greater than the usual growth rate (2.8%) observed over these many decades.

More interesting still, whenever, in the wake of a severe oil-price spike, the Treasury yield-curve has been steeply-sloped — with bond yields well above short-term yields — average year-ahead gains in the S&P 500 price index, S&P 500 profits and industrial output have been even more robust: 16.0%, 21.7% and 3.9%, respectively. Today’s Treasury yield curve is steeply-sloped. That means U.S. stock prices, profits and output have a good chance of rising rapidly (and at above-average rates) over the coming year. The oil-price spike presents no inherent barrier to this bullish outcome.

In addition, the oil price is likely to decline sharply in the coming year. The best way to forecast oil is by consulting the current gold-oil price multiple. As mentioned, today both the gold price and the oil price (in terms of paper dollars) are approximately ten times higher than they were in 1971. On average over the years the gold price has traded at roughly fifteen times the oil price. But when the two commodities have exchanged at a multiple materially lower than this, the typical, year-ahead result has been a sharp decline in oil’s price. Today’s multiple of nine times is close to its all-time low and signals a 20-25% decline in the oil price over the coming year. The multiple last traded at this low a level in March 2001; gold was $262/ounce and oil was $29/barrel. Four months later the oil price was lower by 14%; one year later it was lower by 19%, even though that was only six months after the September 11th attacks.

Could this year’s oil-price spike cause a U.S. recession later this year, or in 2005? Is this the grim future that this year’s sluggish U.S. stock market has been pricing? I doubt it. A look at the six U.S. recessions since 1968 reveals how little the prior oil-price change has related to the magnitudes of subsequent economic downturns and how, in contrast, the Treasury yield-curve spread has been all-important. In two recessions the oil price actually declined in the prior-year period. In two other cases the U.S. suffered from recession even though the oil price had risen by less than 10%; there have been many cases since 1968 when the oil price increased by as much as 10%, yet the result certainly was not recession. In yet another case there was a 199% rise in the oil price prior to recession, yet it was the second mildest recession (-2.0%) recorded since 1968. There’s no basis for the popular belief that oil-price changes reliably signal U.S. recessions.

Not the oil price but the Treasury yield curve is the superior forecaster of U.S. recessions (and expansions). In fact, all six U.S. recessions since 1968 were preceded by an inverted yield curve — a multi-month period when long-term interest rates were below short-term rates. Unlike oil-price shifts, inverted yield curves in the U.S. since 1968 have never failed to accurately predict recession — nor have they ever falsely signaled recessions that never came to pass. Fortunately, today’s Treasury-yield curve is steeply-sloped; bond yields are trading 3 percentage points above money-market yields. That’s nearly “off-the-charts,” historically speaking. Today’s Treasury yield curve isn’t even close to being flat or inverted. That’s bullish. In the coming year the yield curve would flatten or invert — a bearish signal — only to the extent Fed officials “chase” the oil-price rise by materially boosting short-term interest rates. As long as they refuse to do this we can enjoy bullish market results in the coming year — regardless of this year’s oil-price spike.

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Dr. Salsman is president of InterMarket Forecasting, Inc., an assistant professor of political economy at Duke University and a senior fellow at the American Institute for Economic Research. Previously he was an economist at Wainwright Economics, Inc. and a banker at the Bank of New York and Citibank. Dr. Salsman has authored three books: Breaking the Banks: Central Banking Problems and Free Banking Solutions (AIER, 1990), Gold and Liberty (AIER, 1995), and The Political Economy of Public Debt: Three Centuries of Theory and Evidence (Edward Elgar Publishing, 2017). In 2021 his fourth book – Where Have all the Capitalist Gone? – will be published by the American Institute for Economic Research. He is also author of a dozen chapters and scores of articles. His work has appeared in the Georgetown Journal of Law and Public Policy, Reason Papers, the Wall Street Journal, the New York Times, Forbes, the Economist, the Financial Post, the Intellectual Activist, and The Objective Standard. Dr. Salsman earned his B.A. in economics from Bowdoin College (1981), his M.A. in economics from New York University (1988), and his Ph.D. in political economy from Duke University (2012). His personal website is richardsalsman.com.

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