Oil Is Dead. Long Live Oil!

In late June I wrote here that the sky-high price of oil made no sense, and urged investors to get out. This was back when virtually everybody took it as holy writ that the world was rapidly running out of oil, and that unceasing demand growth from the United States and the developing economies of China and India would sustain a permanent bidding war for this dwindling resource.

A week later, oil traded at all-time highs of $147 per barrel. But that turned out to be its last hurrah.

Less than six months later, the price of oil had crashed to as low as $32 a barrel — a 78% drop. Thus, in oil, we have the seemingly impossible: a market that has done worse than stocks.

This brings oil back, on an inflation-adjusted basis, to the general zone of price levels that prevailed for about 30 years, from 1974 to 2004. Back to normal, in other words, despite the fact that world oil consumption has grown enormously over those decades.

And now the know-it-all commentators have completely, shamelessly, reversed themselves. Remember, six months ago, everyone—and I mean everyone, except me—was talking about the world running out. The slogan was “peak oil,” and they didn’t mean a peak oil price. They meant peak oil production. They’re talking about “peak oil” again now, but now they are talking about peak oil demand. I’m reading more and more “expert” opinion that we’ve seen the peak in oil demand from the United States and the rest of the developed world — forever. It’s never coming back.

That tells me that we’re probably near the bottom in oil prices. It’s time to start taking the other side of the bet — to be a contrarian again. Time to take another look at speculating on oil itself (there’s an exchange traded fund (OIL) that allows you to do that easily), or start getting back into the stocks of oil companies. Already the energy sector has been one of the best performing in the rebound from the November bottom in stocks. That could be a useful clue.

I’m not saying oil is going to make a U-turn here and soar back up to $147. I’m just saying I think we’ve probable seen the bottom, or close to it, in the low $30s. From here, with oil at about $41 as of this writing, just a move back to $50 would be almost a 25% gain. Such a move strikes me as eminently plausible in this volatile environment. Even if it’s only a temporary rally, that’s an upside worth betting on.

Looking forward, I don’t doubt that in this global recession oil demand will be slow. It will take quite some time to recover. But the fact that the price of oil is so low will actually be a factor in making that recovery possible. When recovery sets in, oil pricing will rise along with expected demand. So in a strange way, but nevertheless quite real, low oil prices mean higher oil prices in the future.

It’s an example of one of the simplest but subtlest concepts in economics: equilibrium.

Think of what happened last year. Ultra-high oil prices had to be one of the factors that contributed to the global recession we’re in now. When the recession came, demand for oil fell. So the price dropped. See? High prices caused low prices. It works in reverse, too. And that’s where we’re at now.

There’s another factor at work here. In a recession, typically the Federal Reserve lowers interest rates to stimulate the economy. That usually leads to some degree of inflation. And the higher the inflation rate, the more of a floor gets built under the oil price. In this particular recession, the Fed has responded with an aggressiveness never seen before, and in the long run the inflationary consequences are likely to be considerable.

As I wrote here last month, not only as the Fed cut interest rates to near-zero, but it has also dramatically expanded its own investment portfolio. Over the last several months the Fed has bought over $1 trillion in various types of securities, and has announced that it will be buying hundreds of billions more this year. It’s doing this because we’re not only in a recession, we’re in a credit crisis. The Fed is not only trying to stimulate the economy with low rates, but also to heal the broken banking system by acting as the lender of last resort to frozen credit markets.