Oil price run-up built partly on speculation

With oil prices topping $60 a barrel this week, investors have become nervous that high oil prices will cause inflation and that, in turn, will lead the Federal Reserve to raise interest rates further and faster, creating a drag on the economy.

But such a scenario is not necessarily the only one that can occur.

A look at the underlying issues may provide perspective.

First, we believe that at least part of the recent spike in the oil price is speculative and not structural. Structurally – taking into account such factors as demand, capacity and output – many experts see oil in the neighborhood of $40 a barrel. Anything above that price reflects an element of speculation on the part of traders who are chasing the price higher and higher.

The last time we had such a speculative surge in oil was in the 1970s. Energy prices resembled the dotcom stocks of the day. The bubble burst, however, and oil prices plummeted from the early 1980s to a few years ago. It sounds almost incredible now to recall that oil prices dipped below $10 a barrel in the late 1990s.

Now we are in the midst of another speculative flurry. To be sure, the recent surge in the oil price was brought on by rising demand in the face of a scarcity of excess supply. Oil prices had been so low for so long that capital investment in the sector had all but disappeared. So, having worked off a two-decade glut of capacity, prices now are heading upward.

But, while few would argue oil will fall to $20 a barrel, the doomsday scenarios of $80 to $100 a barrel may prove to be an overshot.

Perhaps the inflationary potential of high oil prices is the most important issue and concerns investors most. Oil is one of those rare forces that can slow down the economy while creating inflation. Few other economic forces work that way; inflation usually is created in an accelerating economy.

The Federal Reserve seems to be acting wisely this time in the face of rising oil prices. In the 1970s oil shocks, the Fed “took the bait” and pumped liquidity into the economy to offset the economic slowdown effect of oil, but the spike in liquidity created inflation. The result, in an economy that was more oil dependent that ours is today, was that oil became scarce and expensive. Inflation rose even as the economy slowed, a phenomenon known as stagflation.

During the recent spike in oil prices, the Fed has been increasing interest rates even as the price of oil has risen almost 60 percent in the last year. This time, the Fed has not taken the bait. They have not “monetized” the effects of the oil spike.

The result is that the oil price spike has not created higher inflation – so far. For that, Federal Reserve Board Chairman Alan Greenspan deserves credit. The economy has slowed on higher oil prices, shaving some 0.5 percent off the economic growth rate, but we do not appear to have stagflation.

As a general rule, investors should be careful to look ahead and avoid buying last year’s winners. Remember, oil the commodity is not the same as oil stocks. Most of the upside in oil and energy stocks might be behind us, largely because it is difficult to separate the speculative aspect from the structural. As companies increase capacity in light of huge new revenue windfalls, supply and demand are bound to shift in the future.

Sure, it’s tempting to look back and note that oil-related stocks were ahead 41 percent over the year ending June 22, as measured by the Amex Oil Index. But those who did not invest early – and congratulations to those who did – should be extremely cautious about investing now. It might be too late.

The reason: Outsized returns in any sector are all but certainly not lasting: the market will take them away from you.

Remember, too, that by diversifying your portfolio across asset classes you stand a better chance of participating, at least to some degree, in the next surge, wherever it might occur.