Almost thirty years ago, and I really hate admitting that, I declared my major at the United States Air Force Academy - International Affairs with the emphasis of study on the Middle East and North Africa. Why? Although the Camp David Accords had been signed years earlier and it had been a decade since OPEC flexed its muscles by declaring an oil embargo, the region was still a strategic nightmare for the United States. Most of the countries were dictatorships (yes, some U.S. supported) led by the likes of Muammar Gaddafi, the Ayatollah Khomeini, Hosni Mubarak and Saddam Hussein. Peace with Israel was tenuous at best, with only Egypt agreeing formally to the idea, and imported oil was still the life blood of the U.S. economy.
When I studied the Middle East and North Africa, several things were apparent
even to a na�ve twenty year old: (1) change in any form would come very slowly,
(2) political change, if it occurred, would more than likely be accompanied by violence, (3) oil reserves granted power to the country that controlled them, regardless of the sanity of the ruler, (4) peace in the Middle East would always be tenuous and (5) we as a country needed to end our dependency on foreign oil.
We find ourselves again confronting the issues of uncertainty in the Middle East
and rising oil prices. Oil prices have jumped, but technically, there is no shortage of oil yet. In fact, Saudi Arabia and other OPEC countries are discussing raising production to meet any shortfall. (Oil revenues are now their life blood.) So, why are equity prices reacting negatively to events in the region when there has been a great deal of positive economic news?
Unlike many other commodities which we as consumers can simply choose not to buy, such as gold or silver or even coffee beans, oil is a commodity that influences directly or indirectly the production of every good produced or service provided in some way. When oil prices rise, especially when it happens quickly, it acts like an additional tax on the economy, especially for the consumer. Our dependency on oil, although the nature has changed over the years, still exists.
Let's take a simple example. Two weeks ago it cost $35 to fill your gas tank. This morning, it cost you $40. Maybe you were going to spend that $5 at Starbucks, but today you forego that cup of coffee. Eventually, Starbucks may lose several customers for the same reason, especially if the higher prices persist, but Starbucks has another issue. The cost of delivering coffee supplies to its hundreds of locations is going to start increasing because of higher gasoline prices. If the price of oil remains elevated, it will ultimately impact the cost of coffee bean production. All of this affects Starbucks earnings at least until they find a way to adjust to the "oil tax." But none of that has happened yet except for that one cup of coffee that did not sell today.
Keep in mind the equity market is forward looking. Investors buy stocks today based upon their expectations of corporations' future earnings streams. Until this most recent oil issue is resolved, the market will decide each day as to its influence on corporate earnings several months into the future. The market, in effect, is trying to decide today if and by how much the rise in oil prices is going to hurt Starbucks and other companies' ability to make profits. Tomorrow, that decision can change, and it probably will as more information becomes available.
If you would like to read more about oil and its sway on the economy and the market, please visit www.sdwealthmanagement.com where we have posted J.P.Morgan's March Market Insight titled, Oil and the Economy.