“Everything is soothed by oil,” said Pliny the Elder (AD 23 – AD 79, Roman author, naturalist, and natural philosopher, as well as a naval and army commander). Two millennia ago he was referring to olive oil, not petroleum. But the principle today is the same. Did the Elder hear a Happy Father's Day greeting from his adopted son, Pliny the Younger? History reflects kindly on the two Plinii. It's worth a few minutes reading for those who are curious about Roman politics and antiquity.
Let's leap from ancient Rome to the modern Levant.
We have new highs in Energy sector ETFs. World activity is apparent to anyone who watches television, reads the newspaper, or tracks situation reports from the Middle East and Persian Gulf. We watch Al Jazeera American for this news flow as their reporter depth in these countries seems to be the deepest.
Oil markets are tightening. Risk premiums are widening. The US (WTI) and world (Brent) benchmark pricings are rising. The trend seems to be inexorably up.
We have been positioning for this for a while. Now we are beginning to wonder how high we go, how long prices stay there, and what the sequence of events might be that can lead to a spike higher or a break lower. We are nearly $70 a barrel above the recession low of $40 and within about $40 of the all time high spike a few years ago. Is $150 barrel oil in our future? I recall that the first oil price shock in the 1970s took oil from $3 to $12. By 1980 it was $30.
Rising oil prices translate into higher gas prices and energy costs. When energy prices rise, consumer discretionary expenditures are impacted because higher oil and gas prices act as a tax on the consumer. As we have written in the past, a one-penny increase in the gas price means that, on an annual basis, Americans have about $1.4 billion less for personal consumption expenditures. Gas is mostly consumed as a necessity. The price change incurs an impact every day. It is a dominant and prominent issue that will lead to higher top-line inflation rates and pressures on lower- and middle-income Americans.
The Fed will get its desired higher inflation for the wrong reasons. Oil will not alter Fed policy as this coming week’s meeting will reveal. The tapering path will continue. But oil prices certainly will be a discussion point. Old timers in the Fed watching world recall the dilemma of Arthur Burns who, as Fed Chair in the early 1970s, faced an oil price shock and a weak economy at the same time. The Yellen, Fischer, Dudley troika have a new element on their monetary policy plate.
We hold a portfolio overweight in the Energy sector. The Energy sector is approximately 10.5% of the US market weight. Our weight is now up to about 16%. We did not start at 16%, but the positions we have imbedded in the portfolios over the last six to nine months are higher in price, and we are letting them run. Note that energy sector weights have wide variance in stock market history. They have been as low as 6% in times of oil glut conditions. In 1979-80 at the market top, energy was a 25% weight.
We get nervous when we see new highs with strong upward momentum. That is always a source of worry. In a perfect world, one would seek a gradually rising stock price trajectory coupled with improved productivity, better earnings, and a stable political and financial environment. But that is a pretty picture for a fairy tale. In the real world you do not get it.
Today, we are maintaining the overweight on the Energy sector. We could reduce or eliminate the position at any time, depending on geopolitical events. Or we may let it run for a while. This decision is now driven by geopolitical events and by inner market dynamics. Right now, that position is fully invested.
The flip side of a higher and still-rising energy price is the pressure that higher energy costs put on the consumer. We are underweight in the Consumer Discretionary sector. If the consumer has to spend the money on gas, the consumer does not have the money to spend on something else. Consumers may borrow or invade savings for a while, but that strategy cannot serve indefinitely. With no clear resolution in sight to the situations that drive higher energy costs, this current episode may turn out to be a sustained rise in the energy price with an upward bias. Thus no stabilization is a recipe for retraction or retrenchment in the Consumer sector. We do not want to be invested in a stock market sector that is under pressure and in the midst of retrenchment.
American policy is emasculated and impotent. President George W. Bush got us into Iraq and involved with Afghanistan. President Barack Obama sustained Bush’s policy decisions until the Iraqis refused to ratify an extension of the Status of Forces Agreement. When Iraq refused to extend the agreement, US forces would then have been subject to Iraqi law and not US law. That Iraqi decision triggered an American withdrawal from Iraq. Iraq brought the instability and civil war on itself. We will not help them now.
President Obama also added a 30,000-troop surge in Afghanistan and is now withdrawing those troops. These two presidents have cost the US billions in money and thousands in wounded and dead. Together, they have created the results we now witness daily. They can each look at Iraq and see absolute policy failure. They can each look at Afghanistan and watch the same scenario unfold. What kind of outcome do we claim to obtain when the Taliban cut off the finger of a person who voted in an election? The grizzly scene summarizes what has been accomplished and what has failed.
Americans are tired of seeing this activity. They are tired of watching it on television. America is moving to an isolationist mode. The majority of the country clearly does not want to intervene or send young Americans abroad. America cannot make these regions safer. We are unable to introduce democracy to tribal systems that do not want it. So we now see a wholesale change in American attitude. It has been a long time since the World Trade Center fell in New York. While memories of 9/11 remain vivid, the actions taken because of it are now muted.
That means interventions by the US will be in ways less likely to secure economic outcomes. Hence, terrorist activities are more likely to occur. In the Middle East, we are seeing civil war and an intensification of the ancient division between Shia and Sunni. There is no reason to believe anything other than more intense fighting will occur. The Boko Haram in Nigeria continues to wreak havoc and expand its sphere of influence. It appears to be spreading in neighboring areas as well. This is another oil source region at high risk.
For now, we are overweight in the Energy sector and underweight in the Consumer Discretionary sector. Meanwhile, we continue to watch the news and worry for our country and for those people of good will residing elsewhere. The world is a very dangerous place.
BY David R. Kotok