Triple Digit Recovery Killer

Jim Brown
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Oil prices have returned to the mid $80s and several high profile companies are now predicting $100 to $110 soon. If oil prices do continue higher those triple digit numbers will prove to be a recovery killer.

Since crude prices first crossed over $70 back in June the price of crude has wandered between $70 and $85 with no ill effects. The $70-$80 range was proclaimed to be the perfect price for oil by Saudi Arabia, which allowed for enough profits to justify continued exploration yet not expensive enough to retard economic growth.

With last week's rise to a new 52-week high at $87 the analysts are starting to worry. Personally I believe it was due to end of quarter retirement cash going into commodity funds but others believe it was anticipation of rising demand from the economic recovery.

The currency fluctuations from the Greek debt crisis also played havoc with prices but overall it was repeated daily in the press that demand was growing. Unfortunately the EIA numbers from the last three weeks showed a decline in demand buy nobody is watching.

The mainstream banks upped their estimates in big public announcements, which also helped fuel their existing long positions. Barclay's Capital is predicting $97 oil in 2010. Morgan Stanley is looking for $100 and Goldman $110 early in 2011. They may be just talking up the prices to condition traders to think about the potential for triple digit oil on hopes of stimulating a speculative response.

Unfortunately triple digit oil will be the recovery killer. In the short term it may give the markets lift because the energy sector is up only 2.4% in Q1 compared to 6% for the S&P. If oil moves higher, energy stocks could provide lift for the S&P.

Gasoline prices are closing in on $3 nationwide and it is commonly thought that the $3 handle will begin the process of demand destruction once again. I paid $2.65 at a discount station in Denver today but I saw several posted signs as much as 20-cents higher. Gasoline and diesel prices impact the price of every product you buy. Food costs more consumer goods cost more and manufacturers face additional costs for every phase of the manufacturing process.

Because consumers were shocked by $4 gasoline in 2008 they are relatively immune to the $2.83 national average today. We are in the necessary evil range where it does not break us to fill up the tank but it is not fun. Moving over $3 will produce a psychological toll on consumers and force them to drive less and consume less.

With the average commuter driving 50 miles a day in a 15 mpg car it is not the end of the world but that translates into roughly $12 per day in gasoline plus the normal non commuting miles. That equates to roughly $75 per week per car, or $300 per month. If you are a blue-collar worker at $10 an hour that is roughly 25% of your income after taxes.

That is far better than $4 per gallon but it is more than most workers can afford to pay. Everyone lives up to their means. Most of us live over our means thanks to credit cards and home equity loans. When fuel costs suck out any extra spending money and then starts putting demands on money allocated for other bills there is only one answer. That is drive less and spend less. In America we are somewhat insulated from the higher cost of fuel compared to the developing world. We have a higher income level and a mobile lifestyle that justifies paying 20% of our blue-collar incomes for fuel. In the developing economies the price of fuel is much more critical. Developing economies subsidize fuel cost to consumers in order to allow the economy to develop faster. Still, most countries can't continue to import gasoline at $2.82 and sell it for 50-cents. The IMF estimates that consumer subsidies will still reach $250 billion in 2010. There is a move underway now by many governments to push up this price of subsidized fuel. This is going to slow growth. In companies that don't subsidize the higher real costs are going to slow growth. In the U.K. the cost of fuel today is at the same level as it was at the highs in 2008 because they are having to import more as their production declines and the taxes are higher.

Nobody expects the price of oil to rocket higher today. $100 in 2011 is a done deal but there is no justification for triple digit oil today. In reality there is no justification for $85 oil. OPEC completed some monster supply additions in 2009 and will do so again in 2010. Even with their cheating they still have some four million barrels of excess capacity today.

It is up to them to bite the bullet and start releasing some of that oil into the market to keep prices from killing the recovery. The recovery in 2009 was fueled with an average price of oil at $62. At $85 today that is another 35% higher. Fuel is the biggest consumer expense and a +35% increase in cost over the last 12 months is a major blow. A return to triple digit oil producing $3.00 - $3.25 gasoline will be a drag on the recovery. Diesel prices in the U.S. are already over $3.10 and could hit $3.45 with $100 oil.

We better hope that OPEC oil ministers understand this fact and increase their cheating to put more oil on the market. Current compliance with quotas is only 56%. That could easily drop to 25% without any really negative impact. That would put another million barrels per day on the market. Within a month or so the prices would begin to decline or at least stabilize in the $75 range that OPEC considers the perfect price. For the economic recovery to continue we need that perfect price to reappear quickly. Otherwise we could be looking at a second dip on this recession.

Jim Brown

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