Oil prices are about as close to a crystal ball as an investor can get. They may not be able to tell you which stock is the next Amazon.com (ticker: AMZN), but if you ask the right questions, oil prices can help you predict recessions and forecast inflation.
The price of oil has such predictive power because, like it or not, oil is ingrained in our lives, says Will Rhind, founder and chief executive officer of GraniteShares, a New York-based, independent exchange-traded fund company. “It’s the most important commodity in terms of its usage in the global economy and feeds into everything,” from cosmetics to plastics to cars.
When the price of oil changes, the effect ripples across all sectors of the economy. For enterprising investors who know how to read the signs, there’s tremendous opportunity to profit from oil prices, says Leigh Goehring, managing partner at Goehring & Rozencwajg Associates, a commodity-based investment firm in New York.
[See: 7 Energy ETFs to Buy for Oil’s Comeback.]
Expensive oil can trigger a recession. As with all commodities, the price of oil is driven by supply and demand. When supply exceeds demand, the price falls. When demand exceeds supply, the price rises.
“Oil prices are typically quite volatile,” says Brad McMillan, chief investment officer for Commonwealth Financial Network in Waltham, Massachusetts. “Most of the price action you see is simply noise,” but a significant rise “can really impact the economy.”
How significant does that rise need to be? McMillan says 80 percent or more year-over-year. Historically, price increases of this magnitude have triggered U.S. economic slowdowns and even recessions, he says.
We’re not there yet. Oil prices were about $45 to $50 per barrel this time last year, so the danger zone is $81 to $90 per barrel, he says.
Global tensions being what they are, oil could hit those heights any time. Some geopolitical event no one can foresee could push oil prices above $100 per barrel, Goehring says. A spike like that once would have had negative repercussions for the global economy, but that’s not necessarily true today.
This is how to know if high oil prices are good for the U.S. Demand-based increases in oil prices — like the ones we’re currently experiencing, according to Rhind — are a positive sign the economy is growing.
Investors can tell whether demand exceeds supply from the crude oil futures curve, which continues to be in a backwardation, says Ed Egilinsky, managing director and head of alternative investments at Direxion in New York. A backwardation occurs when the price of a commodity’s futures contracts increases as they near expiration. This is “a sign of immediate demand relative to current supply,” he says.
“Global oil demand has been robust, growing at roughly 1.5 million [barrels per day] annually for the last few years, and we expect this demand growth to continue,” write John Creswell, executive managing director, and David Grumhaus, executive managing director and senior portfolio manager at Chicago-based Duff & Phelps Investment Management, in an emailed response. Although there’s some debate about when oil production will peak, Creswell and Grumhaus believe that’s still at least a decade or two away.
Since the U.S. is a primary oil producer, rising demand is a boon for the U.S. economy. Creswell and Grumhaus say rising production will attract more capital spending from both domestic and foreign sources.
“A dearth of global spending on oil from 2015 to 2017 means there’s unlikely to be a surge in production anywhere except for the key OPEC countries, Russia and the U.S.,” they write. “The U.S. remains in the driver’s seat and will likely continue to be the swing producer.”
[Read: What Investors Should Expect from Oil in 2018.]
Oil prices fueled by a decreasing supply, on the other hand, can be a harbinger of economic downturns, as we saw with the financial crisis. Between the end of 2006 and 2008, the oil market fell into a deficit after OPEC cut supply in 2006. Prices spiked from about $50 per barrel to $145 per barrel by the end of June 2008, slowing down the economies of the world’s 34 most-developed countries.
“We believe we’re repeating in a very similar way what occurred in the global oil markets between the end of 2006 and 2008,” Goehring says. “Our inventory draws have reached the point where any further draws will result in severe upward pressure on prices.”
Financial markets may become strained. Oil prices are one of the primary instigators of inflation, Rhind says. Higher prices force companies to pay more for energy. Whenever the cost of doing business increases, companies raise prices to compensate — and rising prices equal inflation.
As inflation increases, consumer discretionary spending ebbs, slowing overall economic growth. “Sustained market drawdowns usually come in the context of recessions,” McMillan says. “Anything that can kick off a recession is also bad for the financial markets.”
As we approach the $81-to-$90 threshold, “the risks to the financial markets will rise,” he says.
Energy and commodities have the most to gain. Big users of oil like airlines and other companies in the industrials sector are likely to feel the most pressure from rising oil prices, Egilinsky says.
But some sectors, like energy, stand to benefit. “Energy stocks have lagged their commodity counterparts for some time now,” Egilinsky says. “This might represent an opportunity to take advantage of this current differential.”
Naturally, commodities benefit from rising prices. “The era of low commodity prices we’ve had for the past five to 10 years is likely coming to an end,” says Adam Rozencwajg, managing partner at Goehring & Rozencwajg Associates. As a result, investors should have some exposure to commodities, he says.
[See: 7 Commodity Stocks to Buy for Great Dividends.]
Rising interest rates, market volatility and the potential for inflation make this “a good time for people to be diversifying portfolios and investing in asset classes that will likely benefit from this environment,” Rhind says.
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What the Price of Oil Says About the Economy originally appeared on usnews.com
