Fool's Gold

If you've been around long enough, oil as a cause for hysteria isn't a new thing. But President Bush and a whole smattering of politicos and activists want you to believe that this time is different, that we're overly dependent on oil and desperate action is the only solution. Hold on. To be sure, the price of oil hits the average person a bit more at home than other commodities. It's not only used to power our vehicles, but also many day-to-day items we don't generally realize like plastic containers for your toiletries and the wax used to package the frozen food you bought on your last grocery store trip. Maybe that's why oil is regularly high on investors' freak-out list. But there is no need to panic about high oil prices.

A primary concern is our reliance on a finite commodity. People who expound these views tend to subscribe to the Malthusian model of the world. That is, we are slowly biding our time until natural resources run out, potentially wiping out the human race with it. While most probably don't go that far, they still miss the point. Yes, oil is finite. But we were supposed to run out of oil a long time ago. The fact that we haven't is further proof of the power of technological advancements and innovation. Did you know that a state-of-the-art mobile drilling ship can sit in 10,000 feet of water and drill down to 30,000 feet? Fifty years ago, that would have seemed inconceivable. No doubt future innovations would seem even wackier to us now, but they will bring better ways of finding and getting to newly discovered oil fields.

Those who subscribe to the doomsday scenario adamantly maintain no matter how efficient we get, we can't get around oil's depletion. At some price, they are undoubtedly wrong. The price of oil is solely determined by supply and demand. If market forces are allowed to function normally without political meddling, the price of oil will steadily rise in response to oil's dwindling supply. And as that price creeps higher and higher, at some point either an alternative energy source will ease the supply pressures or demand will drop. But one thing is for sure; you won't go to the gas station and find an empty pump. That would only happen if price controls on what producers could sell forced marginal costs above marginal revenues.

Despite what you might think, we are less dependent on oil than ever before. According to the Energy Information Administration, US energy consumption per dollar of GDP has fallen from 15,000 Btu in 1980 to well below 10,000 today. But how can that be with all the 10-mile-per-gallon SUVs on the road? It's simply a function of the fundamental change in our economy. Two of the fastest growing sectors—technology and financials—are much less energy intensive that manufacturing and agriculture, the stalwarts of yesteryear's economy.

So what are the economic and investment implications? Most bemoan high oil prices, citing impeding slowdowns and inflationary pressure. They couldn't be more off-target. In fact, you should actually root for high oil prices. That sounds like it would be a recipe for recession and $1,000 hamburgers, but if that's what you think, you're not thinking about it correctly.

Outside of a few minor supply disruptions, the price of oil has risen in recent years because of strong demand from an expanding global economy. Higher oil prices are a symptom of a healthy, expanding economy, not a sick one. But even if you don't buy that, high oil prices won't hurt society. As mentioned before, they have minimal impact on the economy overall as we have shifted to less energy intensive sectors for our growth. To wit, GDP has risen in recent years in tandem with oil prices. Today oil and petroleum-related products account for only 2.5% of our GDP. With average annual nominal economic growth of 6% in the past several years, this number is only going to get smaller and smaller.

In addition, high oil prices are actually deflationary for other goods. That may sound completely wonky, but think about it for a minute. If you're spending an extra dollar a gallon on gas every time you fill up, that leaves you less money for other goods. Maybe you're affected by the price increase enough to start budgeting on your other purchases. That decrease in demand will lead to lower prices elsewhere. Said another way, if the overall price level is fairly stable, and certain components such as oil rise, then other components must fall.

On any given day, you can log onto your favorite financial website and see any number of stories about high oil prices leading stocks down or a fall in oil prices spurring a rally. Don't believe the hype. Journalists are just trying to find any explanation for the market's movement that day. But quite simply, there is no relationship between oil prices and the stock market. A correlation coefficient measures the degree variables move together on a scale of -1 to 1. A correlation of 1 means the two variables move in tandem, while a correlation of -1 means they move in exact opposite directions. Oil and stocks have a correlation coefficient of -0.1 from 1982 to 2006. That is, they don't correlate at all.

Oil won't sink stocks, the economy, or your existence. If you must, find something else to worry about because high oil prices shouldn't bother you.