With the price of gasoline near $4 per gallon, oil is having an impact on our lives again. Oil is trading at $105 per barrel as of March 7, well above the $90 per barrel level at the start of the year. The obvious concern is the impact this will have on the economy and the stock market. If prices stay near current levels, the impact should be minor, but should they rise to $125 per barrel or higher for a sustained period of time, the effect would be significant.
The current turmoil in Libya is the obvious culprit for the spike in oil prices. Libya accounts for about 2% of world oil production, and approximately half of that total is currently offline. A 1% reduction in world oil supply may not appear significant but because oil demand is highly inelastic, there can be significant price moves. There is also a fear premium that other countries in the Middle East may experience oil outages due to political unrest. Saudi Arabia has increased its production to make up the shortfall but it will likely take months for its oil to reach refineries.
Oil shocks have traditionally been very negative for the economy and the stock market. The oil embargo in 1973 and the Iranian revolution in 1979 caused major oil spikes, which led to severe recessions in 1974/75 and 1980/82. The major price spike in oil during 2008 was caused by strong demand in emerging markets, and a weak U.S. dollar, though the ensuing recession resulted primarily from inappropriate bank lending and the collapse of the housing market.
There are significant differences between this oil price increase and previous ones. Prior spikes in the 1970s and in 2008 were much larger percentage-wise versus this increase. In addition, oil is less significant to our economy than it was 30 years ago. For example, current U.S. oil demand is essentially the same as it was in 1980 despite the real economy being more than twice as large today.
Future worldwide oil demand will be influenced largely by emerging markets. After the recession of 2008/09 there was significant excess oil capacity, however, strong global growth last year significantly reduced the excess supply. Alternative fuels will not likely play a major role for many years. Iraq has the potential to significantly increase its oil production, but the pace of that improvement is highly uncertain. Therefore, oil prices will likely remain relatively high but volatile.
For an investor, keeping a moderate weighting in energy stocks is appropriate. If you are currently in diversified equity funds, there should be representation in energy-related companies. For someone invested in individual stocks, energy is 13% of the market, so a weighting in that range is reasonable. It may be tempting to own a larger percentage of oil stocks, but commodity prices are highly volatile, so your risk profile would increase by doing so.
If oil prices stay near current levels, the outlook for stock prices remains reasonably positive. However, there is the potential, though not necessarily a high probability, of further oil disruptions in the Middle East. For that reason, I would not recommend equity weightings much above your normal range, especially given the strong move in stock prices over recent months.