Despite slackening demand from a world headed into recession, the Organization of Petroleum Exporting Countries reportedly has decided to maintain current production quotas. It is beginning to seem likely that the price of oil, which has fallen by nearly a third in the last two weeks, will remain low for some time.
That would be a rare spot of good news for the U.S. economy. The threat of higher energy prices is one of the biggest bogeys the country faces in working through the current downturn. Most economists expect economic growth to return sometime in the middle of next year, but they worry there might be a spike in fuel costs that would prolong and deepen the recession.
"Higher energy prices will just deepen this thing a lot," says Morgan Stanley chief economist Steve Roach. "And it's going to be deep enough already."
Such fears aren't without basis. Even though market forces typically dictate that a sharp drop in demand leads to lower prices, the supply part of the equation remains uncertain. One cannot reject out of hand the possibility that the U.S. reaction to the Sept. 11 terrorist attacks will disrupt the flow of oil from the Middle East.
But as time wears on, such a likelihood recedes. "With every day that passes without the allies launching a lashing-out attack, the more we think this is going to be very carefully thought through and very focused," says Lehman Brothers chief global economist John Llewellyn. "The right approach is that things would have to go pretty badly wrong in the Middle East for oil to become an issue."
The energy market has apparently come to the same conclusion. The benchmark West Texas Intermediate Crude closed today at $21.30 a barrel, its lowest level in nearly two years. Immediately following the attacks on the World Trade Center and the Pentagon, crude prices rose as high as $31.
Meanwhile, OPEC's decision not to lower its quotas shows not just an understanding that higher prices could simply hurt energy demand further, but that a production drop would be perceived as a swipe at the U.S. Not all OPEC member nations are particularly friendly toward America, but none of them want to be seen right now as allying themselves with U.S. enemies. Drawing parallels between what may happen now and what happened in the Gulf War and the Yom Kippur War doesn't make much sense.
"The emphasis on a war premium has been overdone," says Tom Petrie of energy investment bank and research house Petrie Parkman. "At any given point over the next 12 months, oil and gas prices are going to be lower than they were a year ago."
Drowning in Oil
Yet the drop in energy prices does not necessarily mean that the stocks of integrated oil companies and independent producers have become bad investments. Petrie says that the silver lining in the price drop is that the energy market looks like it will enter contango, meaning that futures prices are progressively higher across longer-dated maturities. Contango makes it easier for companies to profitably use the futures markets.
Moreover, on a relative basis the energy complex is much more attractively valued than other cyclically driven industries, says J.P. Morgan equity strategist Tom Van Leuven.
"If demand for energy is going to be very low, than demand for many other cyclical products is likely to be low," he says. "Yet energy has much more conservative estimates than other cyclical sectors do." According to Thomson Financial/First Call, analysts expect
energy companies' earnings to drop by 15% in 2002. Meanwhile, they expect earnings to jump 74% at basic materials companies, 15% at capital goods manufacturers, 23% at consumer cyclical companies and 64% in the tech sector.
J.P. Morgan's equity strategy group has been advising people to stay away from virtually every cyclical area of the economy except energy. "It's a hedge for our otherwise very defensive portfolio," says Van Leuven. "It's the one cyclical area where we think earnings revision risk is relatively low."