How Does Oil Impact the Economy & Your Portfolio?
Written by Thomas M. Geier, CPA, CFP ®, PFS
Humans have been making predictions for centuries. The ancient Romans and Greeks prophesized based on the cardinal directions of birds in flight. The Farmer’s Almanac’s weather prognosticator predicts the weather using information like sunspot activity, the tidal action of the moon, the position of the planets, and more. Scientists of today can predict where major earthquakes are likely to occur based on the movement of the Earth’s plates and the location of fault zones. And investment researchers and analysts watch key economic indicators, such as oil prices to help predict recessions and forecast inflation.
With the volatility the markets have experienced recently, we surmised there would be interest in exploring the latter of the examples referenced above.
Why Does Oil Have Such Power?
There are more than 1.2 billion passenger cars with over 98% relying on oil, with expectations of that number reaching 2 billion by 2035 and over 3 billion by 2050. In 2015, it was reported the world was consuming 24 million b/d of gasoline and 27 million b/d of diesel fuel every day (1.5 million gallons every minute). Americans consume over 2.6 gallons of oil products every day! In 2017, the U.S. consumed 7.3 barrels of crude oil. The use of oil goes beyond the fuel for our cars and planes to the petrochemicals in our clothing, make-up, upholstery, antiseptics, and paints to the power in machines that move windmills and solar panels. For a more comprehensive list of petroleum products, visit this website.
Oil is everywhere, and therefore a chief constituent of economic growth. So, it stands to reason as the price of oil changes, it generates a domino effect across all sectors of the economy.
The Effect of Rising Prices
If you’ve ever taken an economics class, the term “supply and demand” will be very familiar to you. When supply exceeds demand, the price falls and when demand exceeds supply, the price rises. Oil prices tend to be volatile. Historically, this volatility is often as a result of shocks to demand and supply of oil arising from business cycles, technological advancements, and geopolitical factors. A substantial price increase year-over-year would have a significant impact on the economy, signaling a potential economic slowdown, or if extreme enough, even a recession. The chart below from the International Energy Agency (IEA), shows the demand/supply balance through the 4th quarter of 2018.
Higher prices also trigger inflation. Companies have to pay more for energy, and as a result, raise their prices to counter this increase in cost. Rising prices lead to inflation. As inflation increases, several changes can be noted:
- Consumer discretionary spending shifts, which can slow or stunt economic growth, and the risk to financial markets rise. Basically, the same amount of money buys less than it did in the past. This forces prices upward, as sellers try to gain the same value for their goods. Consumers are left with two options: adjust their standard of living or make more money.
- Inflation also causes one currency to lose value against another. For example, traveling Americans would find their trip to be more expensive, while visitors to the U.S. would be able to spend more money.
- Interest rates rise as banks and lenders adjust for the new value of the dollar, and the government tries to tame the economy.
- Inflation can increase consumer spending as workers will have more money to spend and reduced debt since inflation erodes the principal of debts. However, it also increases prices which can reduce the value of that spending.
Effect on Financial Markets
Typically, the industrial sectors will experience the most pressure during a big spike in oil prices. However, energy and commodities tend to benefit. Stocks in countries that import oil tend to be hurt by higher oil prices, while the opposite is true for stocks in countries that export oil. Areas that tend to spark interest during inflationary periods are:
- Real estate
- Inflation-protected securities such as TIPS (Treasury Inflation Protected Securities)
- Dividend-paying stocks
Rising oil prices can certainly create a disturbance in the markets and has the potential to rattle the economy, but it will not make or break the U.S. on its own. There is enough diversity of industries here to curb the overall impact. Unlike other oil-producing nations like Russia, whose financial health and stability are largely predicated on the price of oil. Just keep in mind, markets are cyclical, and investors will always have to contend with bouts of volatility. Having a well-constructed and diversified portfolio is paramount.
Sources: Forbes/ The Street/ Bloomberg/ Money week/ EIA
© Geier Asset Management, Inc. Jan. 2019. Thomas M. Geier, CPA, CFP ®, PFA is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The articles & opinions expressed in this material were gathered from a variety of sources, but are reviewed by Geier Asset Management, Inc. prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of January 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual circumstances. In all cases, please contact your investment professional before making any investment choices. Geier Asset Management, Inc. is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.