FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
March 15, 2011

IN THIS ISSUE:

1.  No Reason to Panic Just Yet?

2.  Latest Economic Reports Look Favorable Overall

3.  What Mainstream Economists Expect Now

4.  Will Spiking Oil Prices Tank the Economy?

5.  Speculators Are At It Again, As Always

Introduction

With crude oil prices now above $100 per barrel and possibly headed even higher, the main question on everyone’s mind is whether the energy price spike will choke off our delicate economic recovery.  It is impossible to know, of course, because it depends on just how much higher energy prices rise from here.

As I have discussed in recent weeks, the outlook for the US economic recovery received a setback on February 25 when the Commerce Department revised its estimate of 4Q GDP down from 3.2% to only 2.8%.  That was particularly disappointing given that the pre-report consensus was for a rise to 3.4%.

Yet despite that setback, most of the economic reports since then have been encouraging, and most economists and market analysts still seem to feel that the economic recovery will continue this year and probably next year as well.  Just not at a 4-5% GDP clip as some suggested in February.

On top of the disappointing GDP report, crude oil prices have soared to above $100 per barrel in less than a month.  The latest spike in oil prices has virtually everyone dialing back their economic forecasts as this is written, and for good reason, given that no one knows how much energy prices could rise this time around.

The latest spike in energy prices is fueled primarily by the political uncertainties in the Middle East and North Africa.  Here, too, it is uncertain how these developments will play out.  As I have pointed out in recent weeks, the political disturbances in the Middle East could have serious implications for energy prices, the economy and the investment markets.

While political tensions have clearly mounted in the Middle East and North Africa recently, there are still those who blame “speculators” for the recent spike in energy prices.  What else is new?  I will have some comments on that subject near the end of today’s letter.  We have a lot to cover today, so let’s jump right in.

No Reason to Panic Just Yet?

As noted above, the downward revision to 4Q GDP on February 25, from 3.2% to 2.8%, really rained on the party among optimists that were revising their forecasts of growth to 4% or better for all of 2011.  Since that disappointing report late last month, most economists have dialed their estimates back somewhat as would be expected.

On top of the disappointing 4Q GDP revision, we have seen oil prices spike from around $87 per barrel to over $105 in just the last month.  Given the widespread political unrest in the Middle East and North Africa, there is the real chance that oil prices could continue to spike higher, or maybe not, only time will tell.

In 2008 as the credit crisis unfolded, crude oil prices spiked to $147 a barrel, but thanks to the recession and the credit crisis, prices plunged to below $40 by the end of the year – energy crisis avoided.  Yet since then, oil prices have trended steadily higher, with the latest spike above $100 largely attributed to political unrest in the Middle East and North Africa.      

As this is written, there are predictions that oil prices will continue to rise to $125-$150 per barrel in the next several months.  But keep in mind that such predictions are to be expected whenever oil prices rise above $100 per barrel.  This time around, however, there’s no real shortage of oil, so it is certainly not out of the realm of possibility that oil prices could turn lower yet again as the supply/demand cycle has not been repealed.

But for sake of example, let’s assume that oil prices remain at the current $100+ per barrel level for an extended period, or even permanently, but do not explode to the $125-$150 level.  Most forecasters believe that $100 crude oil prices would reduce US GDP growth by less than one-half of one percent per year.

While a reduction of one-half percent is significant, especially when the GDP is growing by less than 3%, it does not necessarily mean that we are headed for a double-dip recession, all other factors considered.  Despite the surprise reduction in the GDP rate for the 4Q, most other economic reports of late have continued to be encouraging.  Let’s take a look at them.

Latest Economic Reports Look Favorable Overall

Consumer confidence jumped to a three-year high over the first two months of this year in both the government’s Consumer Confidence Index and the University of Michigan Consumer Sentiment Index.  Last Friday, however, the Sentiment Index plunged from 77.5 to 68.2, well below expectations, largely due to the spike in energy prices.

It is unclear where consumer confidence goes from here, and much of that depends on whether or not energy prices continue to spike higher.  Consumer spending accounts for apprx. 70% of GDP, so a lot is riding on what happens next with oil prices.  Fortunately, personal income and personal spending were both above expectations in January (latest data available).

The ISM manufacturing and services indexes remain at the highest levels in several years, suggesting that the economic recovery continues to gain momentum.  Factory orders were up a surprising 3.1% in January (latest data available).  Orders for durable goods rose 2.7% in January after falling 0.4% the prior month.

The official unemployment rate fell unexpectedly to 8.9% in February and has declined steadily for the last several months.  Weekly claims for state unemployment benefits have fallen below 400,000 for the last five weeks in a row, although last Thursday’s report was higher than expected at 397,000.  We can all question the validity of how these unemployment statistics are calculated, but the trend is moving in the right direction.

On the housing front, there is also some modest good news.  Existing home sales rose a better than expected 5.1 million units in January.  New home sales, on the other hand, were slightly weaker than expected in January.   But the hands-down best news on the housing front recently is this.

Home loan delinquency rates improved across the board in 4Q 2010.  The total loan delinquency rate fell to 6.5% from 6.9% in the 3Q .  This is well below the peak of 7.5% from a year ago, so the trend continues to fall.  On the other hand, home foreclosures increased 12% in January over December, but that figure was down 11% from January of 2010, so not all bad news.

What Mainstream Economists Expect Now

With the latest spike in oil prices, it is interesting to see what most mainstream economists are predicting now.  To get a feel for that, let’s turn to the latest issue of Blue Chip Economic Indicators (BCEI) which polls over 50 noted economists and forecasters on a monthly basis.  Here are the averages from BCEI’s latest poll taken on March 2-3, after the government revised its 4Q GDP estimate down to 2.8% on February 25 from 3.2% reported earlier.

Despite the recent jump in oil prices, the consensus estimate is that GDP will still rise by 3.1% this year, down only 0.1% from the consensus in early February.  Keep in mind that mainstream economists are slow to revise their estimates, so this number could come down more in the weeks and months ahead if oil prices remain above $100 per barrel.

Not surprisingly, the consensus estimate for 2012 GDP growth remained unchanged at 3.3% in the latest BCEI survey.  As should be obvious at this point, what with oil prices so uncertain, is that any estimates of GDP growth for 2012 are basically useless at this point.

While the latest rise in oil prices resulted in only a 0.1% decline in the consensus GDP estimate, the consensus estimate for the inflation rate for all of 2011 jumped by 0.3%, from 1.9% to 2.2% in the latest survey.  Apparently, most mainstream economists believe that a rise to 2.2% inflation would not cause the Fed to throw on the brakes and send interest rates higher.  We’ll see.

And what do the economists see for consumer spending this year?  As noted above, consumer spending accounts for apprx. 70% of GDP growth.  Despite the latest spike in oil prices, the BCEI consensus opinion is that consumer spending will still rise by 3.1% this year, down only 0.1% from the February survey.

But what about the spike in gasoline prices?  Won’t that cause consumers to spend less?  Some economists believe that the latest rise in gasoline prices is largely offset by the 2% cut in the payroll tax rate which went into place on January 1.  The payroll tax cut is estimated to add some $50 billion in spending power this year.  Unfortunately, that will be more than eaten up by higher gasoline prices if oil prices remain at or above $100 per barrel, so I expect estimates of consumer spending to fall just ahead.

On the housing front, the BCEI consensus continued to worsen modestly.  The consensus on housing starts, for example, fell slightly in the latest survey from 670,000 units in January to 660,000 units in February.  But to keep this number in perspective, the latest estimate for 2011 is 12% above the rate in 2010.  So at least the housing sector nationwide is not worsening as compared to last year and 2009.

Will Spiking Oil Prices Tank the Economy?

As noted above, most analysts agree if oil prices stay around $100 per barrel for the rest of this year, that will shave US GDP growth by only one-half percent or less for the year.  If correct, which remains to be seen, that would cut US GDP growth from a 2.8%-3.0% rate to around 2.5% or slightly lower.  Obviously, that would drive the unemployment rate back up later this year and/or next year.

To put the current oil price situation in perspective, let’s first look back at what happened when crude oil prices spiked the last time.  In January of 2007, oil prices started to rise from just above $50 per barrel.  The price went virtually straight up until the peak in the summer of 2008 at just over $147 per barrel.  The national average for a gallon of gasoline hit a record high of $4.11 in July of 2008.

The price surge took a heavy toll on consumers.  Not only did the cost of driving jump, but prices for other consumer staples, such as groceries, also shot up as transportation costs increased across the board.   In response, consumers drastically cut back on driving and many switched to more fuel-efficient cars.

However, crude oil prices then plummeted to below $40 by the end of 2008, due in large part to the severe recession and the credit crisis.  From mid-2009 to late 2010, crude prices remained generally in a range of $70 to $85 per barrel.  But in November of last year, the current spike began, with crude topping $100 in late February.

As would be expected, forecasts of where the price of crude oil is going from here are all over the map.  The gloom-and-doom crowd says oil is going to $200 or higher (what else is new?).  Even among respected forecasters, there are some estimates that oil will go to $125-$150 on the current run.  And of course, there are some who believe that prices will generally stay at current levels around $100 or perhaps fall back to $90 or so.

While no one knows for sure where oil prices are headed, there are some macro factors that we can look to.  As noted above, the current price spike is not caused by a significant shortage of oil.  Saudi Arabia has increased production to offset the decrease in Libya.  Most oil analysts agree that the current price of crude includes a $10-$15 “risk premium” as a result of the political unrest in the Middle East and North Africa.

The big question is whether or not political chaos will spread to Saudi Arabia, the Middle East’s largest oil producer.  That remains to be seen.  There is already political unrest and demonstrations in Bahrain, a small island connected to Saudi Arabia by a causeway.  The Saudis are already moving aggressively against any signs of unrest among the Shia, arresting dozens who have indicated dissent.  If demonstrations in Saudi Arabia intensify, it could become very bloody very quickly, and it will be interesting to see how fast the House of Saud bans the media from the country. 

In my March 1 E-Letter, I reprinted a column by Dick Morris who warned there is a critical threat that Iran and Egypt could join forces and dominate the Middle East, including fomenting unrest in Saudi Arabia.  Our good friend, Dr. George Friedman, founder of Stratfor, has written an outstanding piece on this very threat.  I have posted a link to this chilling analysis at the end of this letter.  I highly recommend that you read it to understand what is really happening in the Middle East.

If the Saudi government were to fall, to put it bluntly, all hell would break loose at least with regard to oil prices.  In the unlikely event that the Saudi government falls, predictions of $200 crude oil could prove tame.  Most geopolitical analysts do not believe that the current Saudi government is in any real danger of falling anytime soon, which does not argue for a continued spike in oil prices. 

Along that line, the oil bears (and even some who are neutral) note that global crude inventories are high by historical standards at present, which also argues against a further spike up in prices.  Likewise, they argue that the slowdown in oil exports by Libya is likely only a temporary phenomenon.  I point these factors out only to let you know that not everyone is bullish on oil right now.

Speculators Are At It Again, As Always

As oil prices spiked higher in the summer of 2008, “speculators” were roundly criticized for driving oil prices much too high.  As one who has been intimately involved in commodities for almost 35 years, I can tell you that there are speculators in EVERY commodity market.  In fact, there wouldn’t be a commodity market were it not for the speculators who take the other side of trades from the hedgers trying to protect the value of their commodities.  Let me explain.

The commodity futures and options markets exist primarily to provide a mechanism whereby producers, dealers and users of commodities can hedge their price risk.  For example, a corn farmer can lock in the price of his crop by shorting (selling) corn futures months before the crop is actually harvested and brought to market.  Likewise, a jeweler who buys gold on a regular basis can lock in his price of gold months in advance by buying gold futures.  The list of potential hedgers spans many industries around the globe and grows continually.

The hedger is not in the market to make a profit on its futures positions.  Rather, the hedger is in the market in the hopes of insuring a profit on the commodity it produces, deals in, or uses.  Often times, the futures market goes against the hedger, and margin calls must be met to cover losses.  The potential for margin calls is a price hedgers are more than willing to pay to have futures markets which provide a mechanism by which they can protect their profit margins.

Another basic point to understand is that each time a hedger needs to buy or sell, there has to be another entity to take the opposite side of the trade.  Speculators provide the liquidity in the futures markets so that hedgers can get their trades executed.  If a corn farmer wants to hedge his crop today by shorting corn futures at the lofty price of $7.00 per bushel, there will be speculators who believe corn prices are going even higher and will go long and take the other side of the trade.

Thus, there is no doubt that speculators provide an invaluable service in creating liquidity in the commodity futures markets across the board and always have.

Having said all that, there are times when heavy speculation can cause commodity prices to overreach, both on the upside and the downside.  The current situation in the crude oil market may prove to be one of those examples.

As of March 1, traders without a commercial interest in crude oil – the so-called “speculators” – held a record 430,118 crude oil futures contracts on the NYMEX, an increase of roughly 25% just since the revolt began in Libya.

In a bull market, as we currently have, most (but not all) speculators take the long side of the futures contracts they enter into, betting that prices will move even higher.  When there are more buyers than sellers, prices naturally go up.  But that is certainly not the whole reason, or even the main reason, why crude oil futures have spiked higher.

There is no questioning the fact that the risk of an oil supply disruption in the Middle East has risen over the last several months as political unrest in the region has heightened significantly.   This is precisely why most analysts believe there is a “risk premium” of $10-$15 per barrel in crude oil prices today.  So to place all the blame at the feet of the speculators is simply hogwash.

Parting Thoughts

As demonstrations have intensified in Saudi Arabia, the US stock markets have reacted rather violently to the downside.  As I emphasized above, if the Saudi government falls, all hell breaks loose!  At this point, it is way too early to predict that the current Saudi government will fall.  If the demonstrations intensify, there will almost certainly be a very bloody fight that could make Tiananmen Square in China look like child's play before the Saudi King would relinquish power.

Depending on how it plays out, oil prices could potentially soar much higher, and US stock prices could implode.  On the other hand, the House of Saud could remain in power for years to come, oil prices could stabilize at current levels or even lower, and the bull market in stocks could continue for a while longer.  In either case, market risks at the present time are the highest they've been in many years.

As I argued at length last week, I have the bulk of my net worth invested in actively managed strategies that have the ability to move to cash or hedge long positions during serious market downturns.  I also shared my disdain for taking losses of 50% or more as was the case with the stock market in 2008.  You might want to think about the alternative investment strategies I recommend in light of what we see going on in the world today.  

Above all, be sure to read the following analysis from Dr. George Friedman of Stratfor on what is happening in the Middle East and North Africa.  Here is the link, as promised above:

http://www.stratfor.com/weekly/20110307-bahrain-and-battle-between-iran-and-saudi-arabia

Here is an updated analysis from George now that Saudi Arabia has moved militarily into Bahrain, which was posted yesterday:

http://www.stratfor.com/analysis/20110314-iran-saudis-countermove-bahrain

As always, I greatly appreciate Stratfor allowing me to reprint their work from time to time.

Final Note:  I am now reading John Mauldin’s latest book – EndGame: The End of the Debt SuperCycle and How It Changes Everything.  I have not finished the book yet, but I can already tell you that this is John’s best book ever (his fourth).  John and I have worked together on various projects for over 20 years, and I consider John one of my closest friends.  His insights on what our future holds are thought provoking to say the least.  I highly recommend it!

Click here to order from Amazon

Or here to get it from Barnes and Noble

Very best regards,

Gary D. Halbert

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