January 14, 2011

What $100 Oil Means for Investors

Supply and demand should eventually bring down today’s sky-high oil prices.

Lest anyone think soaring commodities were last year’s story, today’s screaming headlines have a very familiar ring. Whereas metals made most of the news in the last two years, now surging oil and food prices are kicking off the year.

Global growth prospects are fueling the move toward $100-a-barrel oil. Growing affluence in developing countries is increasing demand for agricultural products. Economic growth in Asia — most particularly in China — have fed the enormous run up in industrial metals, while doubts about the West’s economic standing continues to support gold’s high valuation.

Of course, discussions of demand would be incomplete without some thought given to matters of supply. And here too, the recent news has added to the wealth of commodity investors.

A leak discovered in the Trans Alaska Pipeline at first shut down the 800-mile conduit and will constrain supplies for some time longer. Even stocks of the pipeline’s owners, BP (BP), ConocoPhillips (COP) and ExxonMobil (XOM) seem to be benefiting from the broader oil market’s rise; the added supply squeeze further boosts oil companies’ profits. Count OPEC as in the happy camp.

While energy prices are going up, water appears to only move down, downhill, that is — which is adding to the human misery experienced by Australians suffering through the epic flood in Queensland, its vast northeastern state.

That water has filled the region’s coal mines and rail tracks that bring the coking coal used to make steel. Australia supplies two-thirds of this vital commodity, whose price is heading straight up — another blow to the world’s already pinched steel makers but good news for commodity investors.

While both supply and demand have enriched investors in commodities in recent years, economic theory and practical experience strongly suggest commodity prices should eventually fall back down to earth.

Econ 101 teaches that rising prices are a signal to producers to bring on more product, which will eventually overwhelm demand with fresh supply. Alternatively, high prices will force producers of products needing a certain commodity to find substitutes, thus reducing demand.

Recoverable oil discoveries in 2010 confirm in practice this economic theory. Mark Perry’s Carpe Diem blog shows 50 billion barrels of oil were brought online through new discoveries around the world, especially in Brazil.

Neither economic theory nor recent oil finds can help investors determine in some consistent way how to time commodities markets. But in the long term, their real return is close to zero.

As for the highest oil prices in more than two years, which have caused so much pain at the pump: In inflation-adjusted dollars there is a clear downward trend over the past 92 years, according to data from the Energy Information Administration cited in Perry’s blog. 

Nevertheless, spikes (especially those experienced during the Arab oil boycott of the 1970s) are seriously disruptive to the global economy and to our personal economies. Hopefully, today’s high oil prices will be the trigger for alternative energy sources that will benefit investors and consumers alike.

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