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The Danger Zone

February 25, 2011 By Jeremy Jones, CFA

With geopolitical turmoil spreading to key oil-producing countries in the Middle East and Africa, oil prices have spiked in the last two weeks. West Texas Intermediate, the key U.S. benchmark, is now trading near $96 per barrel. Brent Crude, the European benchmark, is trading north of $110 per barrel. The increasing risk of an oil price shock has apparently caught many investors off guard. One would have thought that revolutions in Tunisia and Egypt, as well as protests in Yemen, Bahrain, and Algeria, would have alerted investors to the growing risk of a price shock, but they didn’t. The S&P 500 closed last week at a 52-week high. 

It was a different story this week, though. The revolution in Libya, Africa’s fourth-largest oil producer, partially shook investors from their liquidity-induced state of euphoria. The S&P 500 fell almost 30 points or 2% on Tuesday. Stocks also declined on Wednesday and Thursday, but were up almost 1% in early trading Friday—apparently on easing tensions in the Middle East. But based on the potentially destructive consequences of an oil supply shock, the stock market is underpricing risk. 

At current oil prices, certain sectors of the economy are already at risk of experiencing a slowdown in spending. I use the chart below as a crude guide to the impact of oil prices on the U.S. economy. The chart has two panes. The top pane shows estimated oil spending as a percentage of GDP. The bottom pane shows real durable goods spending growth. 


When the value of U.S. oil consumption exceeds 4% of GDP (top pane), durable goods spending begins to slow (bottom pane). At $96 per barrel, the value of U.S. oil consumption is equal to 4.5% of GDP. If oil prices stay at these levels, durable goods spending growth should slow in coming quarters. If there is an oil supply shock, durable goods spending could plummet. With the price-to-book ratio of the S&P 500 Consumer Discretionary Index near a 10-year high, it is difficult to argue that consumer discretionary stocks are priced for such a slowdown. 

It is also difficult to argue that the broader market is appropriately pricing in the risk of an oil supply shock. Oil prices only have to rise about $10 per barrel for the ratio on my chart to exceed 5%—a level that has historically been associated with economic contraction. According to Bloomberg, the average economist is anticipating GDP growth of 3.5%, 3.3%, 3.5%, and 3.5% in each of the next four quarters. If protests and revolutions continue to spread in the Middle East and Africa, the correction in stock prices could accelerate.

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Jeremy Jones, CFA
Jeremy Jones, CFA, CFP® is the Director of Research at Young Research & Publishing Inc., and the Chief Investment Officer at Richard C. Young & Co., Ltd. Richard C. Young & Co., Ltd. was ranked #5 in CNBC's 2021 Financial Advisor Top 100. Jeremy is also a contributing editor of youngresearch.com.
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