Friday, March 11, 2011

Oil Prices: Ouch or Oh No!

As I sat in his chair my barber-economist stated emphatically that, "Four bucks a gallon gasoline will send the economy back into recession."  I told him that he seemed pretty sure about his prediction, and I wondered what he was basing it on.  He said it was simple; in 2008 the economy was humming along and when a gallon of gasoline pushed toward four bucks, the economy just fell apart.

As he began snipping away at the few locks of hair that I still have, he asked, almost as an afterthought, "What do you think?"  My barber is a good guy and he can carry on a conversation on just about any subject with anybody, and I could tell that the hottest topic in the barbershop in recent weeks had been the skyrocketing price of oil. It was also clear that the consensus of my barber and his patrons was that another recession loomed.

As I began to answer, I thought about the proper degree of diplomacy one should display in disagreeing with a man who is both bigger than I am and armed with scissors and a straight edge.  Thus, I began philosophically, which is always a good way to disagree with someone and yet, blame it on someone else.  I answered, "Mark Twain once said that history does not repeat itself, but it rhymes."

Because I did not understand what Mr. Twain was saying the first half dozen times I heard his aphorism, I quickly interpreted.  "Consumers and businesses can adapt to about anything that they have seen before and can quantify."  I continued on for a few minutes by explaining that I had just read an article in the New York Times about how people and businesses were becoming more efficient in their automobile use. Whereas, prior to the rise in gasoline prices a person might do some form of shopping everyday, they were now working more from a shopping list and making fewer trips.  Thus, the total dollars of their purchases was about the same, but the money they were spending on gasoline was lower

He wondered about all the people, such as himself, who did not have a choice in the matter because they had to drive to work everyday.  I said the article explained that even everyday drivers were conserving by minimizing impulse driving on the weekends.

He is not only an economist-barber, but also a fast barber, as well, and he finished my haircut without much further discussion about oil or the economy. I was sitting in my car with my hand on the ignition when an awkward thought crossed my mind: What if he's right and I am wrong?

It may surprise you to know that I think that thought a lot.  I seldom have any serious doubts about the strategies we employ in managing portfolios.  We are conservative and we pay close attention to our valuation models, so we have far fewer sleepless nights than, say, a hedge fund manager or an aggressive growth manager.  Having said that, we still have to take sides on lots of macro-economic issues and the biggest issue we have to deal with today is the rise in oil prices.

As I drove out of the barbershop parking lot, I began an exercise I must have done a thousand times:  computing how much the average family pays for gasoline in a year. If the average family drives about 20,000 miles per year and their automobiles get about 20 miles to the gallon, they will use about 1,000 gallons of gasoline a year. At $3.00 per gallon, the price before the recent run up, they would spend approximately $3,000 per year.  At $4.00 per gallon the average household would spend a thousand dollars more per year.(As I write this, Reuters is reporting that the average family will spend approximately $700 more at current prices.)

We know that the median family income in the US is about $50,000 and in 2010 the savings rate was approximately 6%, or $3,000.  That would mean that there is plenty of room in the average American's budget to pay an additional $1,000, excluding their attempts to economize that the New York Times described.

The problem, of course, is what if consumers decide to maintain their 6% savings rate.  That means they would reduce annual spending on other goods and services by a thousand dollars per family.  History, however, shows us that the savings rate has fallen in almost all of the oil spikes.  Consumers appear to intuitively determine that the oil spike is temporary and they do not dramatically adjust their overall spending.

As I drove down the road, I concluded that neither $100 per barrel oil, nor $4.00 per gallon gasoline would send the economy back into recession. Furthermore, with most measures of the economy pointing firmly in a positive direction, I could not agree with my barber friend, nor those who are predicting an imminent recession.

Driving a little farther, another awkward thought crossed my mind.  If the current regime in Saudi Arabia were toppled and control of their oil fields fell into the hands of radicals, oil prices could go to $200 per barrel and an worldwide economic recession would be much more likely.

When I got back to the office, I did some quick analysis of the relative prosperity of Saudi Arabia versus some of the other embattled African countries.  I found that the average per capita GDP of Saudi Arabia is nearly $30,000 per year.  That is over two times the per capita income of Libya and five times that of Egypt.  There are issues other than income that are causing the revolutions in North Africa, but the average Saudi Arabian is much better off than the citizens of almost any other country in the region.

In addition, Saudi Arabia has formidable military and police forces that are well cared for by the Saudi princes.  It is doubtful that the military would turn on the rulers as they did in Egypt. Indeed, the royal family has it own military.  Finally, the royal family, much to the displeasure of the US and our allies, has funded the Wahhabi Islamic clerics in the country for many years.  Thus, the clerics are not likely to lead a revolt.

Religious tensions do exit between the ruling Sunnis and the minority Shiites Islamic sects. Iran has long been rumored to be trying to incite a Shiite uprising.  Without some complicity by the military or an invasion by Iran it is very doubtful that the Shiites have the critical mass to overthrow the government.

My conclusion is that the royal family in Saudi Arabia will survive and in doing so, should preclude oil prices reaching prices that would produce a worldwide recession.  It is only a guess, but I would say that the odds of the Saud royal family falling are less than one in twenty.

We are in for some very volatile days in the stock market as the serial revolutions unfold in North Africa.  It will take many months for new leadership to form in many of the countries. Also, the civil war in Libya could last longer than most people think.  In the meantime, as long as oil prices don't go up another 50%, I believe worldwide economic growth will continue at near its current pace.

As I said earlier, we have to come down on one side of the impact of higher oil prices or the other.  For the present, after reviewing the available facts, we are taking the optimistic view.  We believe the oil spike is just that, a spike that will later be at partially erased. As events unfold, however, we could change our minds in short order.  If we do, we'll let you know.

If our view of things is correct, any sell off in the market would provide good buying opportunities for many of our current holdings, including some of the purchases we have made in recent weeks.