Why Do Oil Prices Really Fall?

Jim Brown
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I continue to get emails asking why oil prices are down. First, they are normally down in Sept/Oct as the demand cycles and products change. This is normal. However, there are other reasons with a lot more impact.

The biggest problem impacting energy prices and equity prices remains the worry over the European debt crisis, the potential for a European recession, worry over a hard landing in China and worry over a potential return to a recession in the USA.

A recession, whether caused by a sovereign debt crisis or high unemployment, is still a recession and typically that reduces demand for oil products. Investors are anticipating that reduced demand and reducing investments in oil futures and energy equities.

They may be right or they may be wrong but the key point is that this is a short term problem. Even if a recession did appear it would not be the same type of recession as we saw in 2008. This one would be a normal recession where GDP declines slightly, prices for products decline as demand slows. Most people in the U.S. never know when we are in a normal recession. Normal recessions occur about once every five years for 2-4 quarters. They are not noticed because they are mild and are only talked about in the financial press. Having Peter Jennings report on the World News Tonight that the GDP for a quarter declined -0.5% will be ignored by the majority of viewers. If we have another recession it will likely be normal, shallow and mostly ignored. By comparison the 2008 recession saw GDP decline average -4.14% and it lasted six quarters. At its lowest it was -6.8% in Q3-2008.

GDP Chart

Corporate America is prepared for a normal recession. They have reduced expenses to the bone over the last four years and they have stockpiled significant amounts of cash. They have refrained from hiring large numbers of people until the recovery is well under way. The rebound from the Great Recession stalled at 3.5% and began easing again under the weight of the massive unemployment and the worries over the European debt crisis.

The recent economic reports do not show the U.S. falling back into recession. The ISM was positive, auto sales were strong, retail sales have been good and the employment components of the various regional manufacturing reports have been strong. The ADP Employment report on Wednesday predicted a gain of +90,000 jobs for September. That is not much but should the Nonfarm Payroll report agree on Friday it would be market positive and suggest no immediate recession. Conditions are improving in the U.S. but it will take a long time to put everyone back to work. More than likely 3-5 years. That does not mean the U.S. will be prevented from growing but it does suggest 2.0-3.0% GDP growth for several years.

I had a long talk with a relatively novice investor today. He had bought into the End of America advertising currently being blasted over the airwaves and print media by Porter Stansberry and others. Basically they are trying to convince everyone the dollar is going to zero and there will be bread lines in the streets when the dollar loses its place as the world's reserve currency. I am not disputing it can't happen and unless the idiots in Washington, Republicans and Democrats alike, start making some serious changes soon it really could happen. With a national debt of $14 trillion, not counting entitlements, and projected to go to $20 trillion by 2020, we could lose that reserve currency status.

What that will do is crush our dollar. I mean REALLY crush it as in massive inflation with prices exploding out of sight. Unfortunately that will have long term consequences too complicated to discuss here but suffice to say it would be the end of the world as we know it in the USA. I want to make clear I DO NOT EXPECT IT but it is possible.

When the dollar is crashing as it must when the Fed goes into overdrive to print money and try to prevent a future recession or worse, the value of hard commodities will soar. I am talking about oil, metals, etc. Knock 20% off the dollar and the price of oil will rise 40% or more.

In 2008 at the height of the oil spike the dollar index was trading under 72. Crude prices rose to $147. The dollar index rose to 89 in Mar of 2009 and oil sank to $33.

Dollar-Oil Comparison Chart

Oil moves directly opposite to the dollar regardless of the demand-supply equation at the time. When Europe finally gets their sovereign debt crisis fixed the euro will rebound and the dollar will fall and probably fall sharply since the Fed is still buying treasuries.

The dollar has been strong in recent months because it is the safe haven currency with the euro in turmoil. It cannot remain high. Once there is no need for the safe haven those investors will move it elsewhere and the dollar will fall again. If the U.S. lawmakers pull another debt ceiling debacle stunt at the end of November the dollar will fall. There are any number of possible scenarios but in the end the dollar will fall in the long run until our economy begins speeding up again.

Where I differ from the end of the world scenarios is I don't believe the lawmakers in Washington, the administration, Federal Reserve and Treasury will let America go down the drain. I believe the closer we get to a real crisis of confidence the more action will be taken. Unfortunately it could take a decade or more to actually get out of this mess. During that time the dollar will be weak. How weak is unknown.

Fortunately we can protect ourselves by investing in dollar denominated assets like oil, precious metals and oil producing energy stocks.

You may have noticed that nowhere in the prior paragraphs did I mention Peak Oil or oil shortages. We don't have to rely on those to push up the price of oil long term. However, those factors will enter in to the equation and push prices even higher. What I am worried about is the resulting global recession that will occur once we pass that point where demand exceeds supply and the dollar is weak as well. The aftershocks of the coming oil shortage will have lasting impacts far into the future.

If you have endured my writing and actually picked up some oil producing energy stocks along the way you will be very grateful in the years ahead. What I don't want is for anyone to be looking back and saying, "Dang, I sure wish I had listened!"

Energy stocks are on sale today. Compared to where they will be 24-36 months from now they are positively cheap. The bear market in equities and the European debt crisis have given us a golden opportunity. Please take advantage of it.

Jim Brown

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