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Renowned financial analyst Stephen Leeb asserts that in this perilous period, oil prices will drive all other economic indicators. This volume details how to diversify holdings to avoid potential disaster.

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The Oil Factor

Warner Books

Chapter One

The most important events in history, the ones that will have the greatest impact on our lives for years to come, often slip by unnoticed at the time. Go to a library and scan issues of the New York Times from the fall of 1960. What was making news in that presidential election year, apart from coverage of the Kennedys' glamour and Nixon's five-o'clock shadow? Two tiny islands called Quemoy and Matsu; and Nikita Khrushchev; and our fledgling space program.

Definitely not grabbing headlines, in an era when oil was priced at under $2 a barrel and the U.S. satisfied around 70 percent of its oil needs through domestic production, was the decision, in September 1960, by five countries-Iran, Iraq, Saudi Arabia, Kuwait, and Venezuela-to form a loose coalition called the Organization of Petroleum Exporting States, or OPEC. But the ultimate repercussions of that event have been massive. In fact, as we will detail below, it is no exaggeration to say that OPEC, which gradually expanded to include Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, and Ecuador, has become the single most important determinant of the health, or lack thereof, of both our economy and our financial markets.

Ten years later, another oil-related economic milestone also got little attention. In 1970, U.S. domestic oil production, which up until then had been consistently rising, embarked on a decline, one that has continued ever since. To the extent that anyone noticed it at all, it was viewed as either a temporary anomaly or as simply no big deal. Like the formation of OPEC, however, the decline in domestic oil production has been of critical importance to the economy and to investors.

Oil is key to all we do, to every facet of our economy. Or to put it more precisely, energy is key, and for now, because of a long-term failure spanning administrations of both parties to develop alternative energies, energy means oil. Our need for oil, our growing appetite for this critical resource, is the prism through which it is essential to view all that is happening in the world today and all that will occur tomorrow. This is true for all of us, citizens in general. And it is true in an even more specific way for investors who want to understand what is likely to happen in the financial markets in coming years and what they need to do to protect themselves and profit.

Above all, it's essential for investors to grasp, intellectually and viscerally, the following realities:

For the last thirty years, the price of oil has been the single most important determinant of the economy and the stock market. Sharp rises in oil prices have been deadly for the economy and the stock market, while steady or declining prices, or even prices that increase only gradually, have led to good times. For investors, it's what we dub your "desert island, one phone call" indicator. If you can know only one thing about the world, make it the direction of oil prices over the preceding year, and you'll do better in the stock market than almost anyone else following any other indicator, from interest rates to corporate profits. This has been true for the last three decades, and it will remain true throughout the early part of this century-until we kick our oil habit and develop and switch to viable energy alternatives.

Oil prices are a determinant over which, for the past thirty years, we have more or less ceded control. In other words, through good times and bad, we have exercised little real control over our own economic fate.

Finally, the situation is about to shift from bad but acceptable to worse, because, as we'll detail in chapter 3, for all practical purposes the world is running out of economically extractable oil. This puts us more than ever at the mercy of the very few nations with significant untapped reserves-Saudi Arabia and to a lesser extent Iraq, Iran, and Kuwait. Over the long term it's clear that the only viable solution is to free ourselves from our dependence on oil entirely, by shifting to other forms of energy. But in the meantime, we are trapped in a tricky and dangerous present, in which we need to ensure that we have the oil we need to keep the economy going while we seek to develop alternatives on a meaningful scale. This doesn't mean that the economy is doomed or that there aren't significant profits to be made in the stock market during the tumultuous transition that lies ahead. It does mean, though, that you have to know what to look for-in particular, that you need to watch oil, tracking the direction of oil prices at any given time and then tailoring your investments to fit what oil dictates.

Below and in following chapters we'll discuss these three key points in detail. We'll explain where to go to find oil prices at any given time, how oil ties in with other salient economic realities, such as super-high levels of consumer debt, and what this means for the short-term and long-term outlook for the economy and stocks. In particular, we explain why the upshot is likely to be high and rising inflation accompanied by the ever-present risk of deflation, a volatile combination that will transform the investment environment. And we'll tell you exactly how to use trends in oil prices to catch each investment wave and to profit whether stocks are going up or down. In this chapter, though, we'll look at the recent past-at the decisive though often surprisingly overlooked hold oil has exerted over our lives for the past thirty years.

A Brief History of Oil Prices

It is striking, if you look back at the past thirty years, how closely changes in oil prices have mirrored both the economy and the stock market. During this period, rising oil prices have always preceded economic downturns and falling stocks. Falling oil prices have always led to economic upturns and rising stocks. It's that simple, that predictable.

And there is good reason for this strong correlation. For a long time, oil has been our major energy source, and economic growth depends on the availability of energy as much as the growth of a child depends on the availability of food. When energy is available at low prices, the outlook for growth is good, and stocks go up. When energy prices go up, growth becomes harder to achieve, and stocks go down. Now, you might point out that our economy has run on oil for longer than the past thirty years, and that's true. But in those earlier years, no one ever thought much about oil prices. Oil was just there, like air and water-other commodities we gave a lot less thought to back then. It was cheap, it was plentiful, and it was dependable. Businesses could count on getting all they needed, and so could consumers.

In the fall of 1973, that age of innocence vanished forever, as a result of the 35th OPEC conference, which began in Vienna in September and ended in October. This event transformed our economic landscape and forever changed how we think about oil. During that conference OPEC imposed restrictions on oil exports. In so doing, it engineered a 70 percent increase in oil prices, which rose to the then unheard-of level of more than $5 a barrel. In December the cartel met again, this time in Tehran, and took even more drastic action. Protesting U.S. support for Israel in the 1973 Yom Kippur War, it temporarily embargoed oil exports altogether. By early 1974 oil prices had jumped to more than $7 a barrel, more than 130 percent above levels that had prevailed just a few months earlier, in mid-1973, and, indeed, for the entire preceding decade.

OPEC had done what the Soviet Union, throughout the Cold War, had failed to do-demonstrated not by threats but by action our vulnerability to forces over which we had no control. The cartel continued to flex its muscles, and oil prices continued to rise throughout the 1970s, in a steady but constrained uptrend. Then the situation abruptly worsened. Propelled by the overthrow of the shah of Iran and the Iran-Iraq War, oil prices soared. By the end of 1979, oil-which had averaged a shade over $10 a barrel in 1978-was more than $18 a barrel. And by early 1981, prices had reached nearly $40 a barrel.

Then the pendulum shifted again. The reason: the West had reacted to the rise in prices by cutting back on its oil use through a combination of conservation and the development of other energy sources. Heavy investments in nuclear power and the development of coal and of oil fields outside of OPEC's reach began to pay dividends. The combination of lower demand and increased supply drastically reduced OPEC's ability to control prices. As a result, oil prices were in nearly free fall during much of the 1980s. From their highs of nearly $40 a barrel early in the decade, they plunged to a low of near $10 a barrel in 1986.

By mid-1987, though, oil prices rose significantly once more, though getting nowhere near their previous highs. The reason for the rise was, once again, OPEC, which, alarmed by prices in the single digits in 1986, had reined in production slightly. For the next three years oil prices fluctuated between the mid- and high teens without any obvious trend.

You probably remember what happened next. On August 2, 1990, Iraqi president Saddam Hussein ordered his army to take over Iraq's nearly defenseless neighbor, Kuwait, a Muslim country whose population numbered only about two million. Though Kuwait was barely a speck on the map and shared virtually no Western values, it took just twenty-four hours or so for the UN Security Council to order Iraq to withdraw. Why such a fuss over Kuwait? Oil, and a lot of it. Kuwait, a founding member of OPEC, was one of the world's largest oil producers. It was clear that Saddam had only one thing in mind, and that was possession of Kuwaiti oil. The threat of so much oil in the hands of an unpredictable dictator was enough to make the West act, and act decisively.

As the Gulf crisis unfolded, the oil markets responded by driving up the price of oil by over 50 percent in just a few weeks. A number of catastrophic scenarios were being bandied about. The most alarming one was damage to Saudi Arabia's oil fields. Many analysts argued that a desperate Saddam would send missiles to every corner of the Middle East, inflicting untold economic damage in the West. Saudi Arabia was considered the most likely target because it was the world's largest producer of oil. Oil prices soared to above $30 a barrel.

Once the shooting started, however, in mid-January 1991, it became clear that Saddam offered no real resistance and lacked the means to damage the Saudi fields. Though the Kuwaiti fields were left aflame, the Saudis had more than enough capacity to make up for the shortfall until the Kuwaiti fields were repaired. As a result, by early 1991 oil prices had fallen back to the high teens. For most of the rest of the decade, prices remained well under control. Oil hovered near $20, with the average price a shade above $19. Moreover, as figure 1a, "Oil in the 1990s," shows, whenever oil peeked above $20, it quickly backed down. Remember, too, that $20 oil in the 1990s was comparable, after adjusting for inflation, to $15 oil in the 1980s. It wasn't until the end of the decade that oil began to display any volatility at all. In 1998 OPEC, because of an internal battle over market share, turned on the taps full blast. The extra oil hit the markets just as the Asian economies were entering a serious swoon. At their lows in 1998 oil prices dropped to $10 a barrel. OPEC became more disciplined in 1999, and oil prices recovered all the way back to the mid-20s on the heels of surging economic growth. Oil finished the decade at about $25 a barrel, not alarming but still the highest level since the Persian Gulf War of 1990-91.

Oil, the Economy, and the Stock Market

During the years between 1973 and the turn of the century, while oil prices bounced up and down between a low of around $10 a barrel and a high of near $40, we experienced five recessions and several periods of strong economic growth. Meanwhile, as far as stocks went, we've had bear markets, in which stocks dropped nearly 50 percent, and some prolonged and glorious bull markets. Who says life is dull?

The point is that if you looked at when the economy went into a tailspin and when stocks tanked, you'd see that these periods were always preceded by rising oil prices. By the same token, falling oil prices preceded economic good times and strong financial markets. It's like those acetate overlays in books depicting the human body, in which a sheet depicting branching blood vessels lies neatly over a sheet showing the skeletal frame. If we had such overlays, we could fit economic and market trends snugly within changes in oil prices.

Let's briefly look back at the economy and market during those same thirty years since 1973 and see just how their ups and downs intersected with trends in oil. It is no coincidence that the period 1973-82-which saw oil prices rise from below $5 a barrel to nearly $40 a barrel-was one of the most turbulent in U.S. economic history. Inflation soared into double digits, and the economy experienced three recessions. Moreover, during those years, economic dogma was rewritten. Until then there was a well-established relationship between economic growth and inflation. When growth was strong, inflation would pick up; when growth was reined in-by rises in interest rates and a tighter money supply-inflation would fall.

This relationship, which had long been a reliable road map for economic policy, was blasted out of the water by events in the 1970s. Because of our lack of control over oil, inflation and recession were no longer mutually exclusive. As OPEC engineered rises in oil prices, prices rose across the board, even in the face of a slowing economy.

In the 1970s, a new term entered the economic lexicon: "stagflation," a combination of stagnant growth and high inflation. At times we didn't know which of these enemies to fight first. In 1974, thanks in part to Alan Greenspan, then economic adviser to President Ford, Americans were urged to wear "WIN" buttons, standing for "whip inflation now." Those buttons were quickly discarded when it turned out that a more devastating enemy was the recession that had started in 1973 with no one noticing.

Well, not exactly nobody-the stock market clearly noticed. The year 1974 was one of the worst ever for stocks. Between the start of the oil embargo in December 1973 and their low in 1974, big-cap stocks as measured by the S&P 500 plunged by over 30 percent, while smaller-cap stocks suffered even more damage. With the exception of gold stocks, nothing was spared.

For the remainder of the 1970s, with oil uptrended but not abruptly so, and inflation seemingly on a permanently higher plateau, stocks treaded water.

Continues...

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Excerpted from The Oil Factor by Stephen Leeb Donna Leeb Copyright © 2004 by Stephen Leeb and Donna Leeb. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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