The case for gloom is, I admit, plenty strong.
Consumer spending, the big source of growth for the U.S. economy in this economic cycle, continues to slow, with growth dropping to 2.6% in the second quarter from 4.8% in the first quarter of 2006.
The real estate money machine that fueled that growth in consumer spending has run out of gas. New-home sales are falling -- down 4.3% in July -- and housing prices have flat-lined in many parts of the country. The housing market could get even cooler in 2007. On average, housing prices will climb just 0.43% in 2007, according to a survey of 48 economists by
The Wall Street Journal
. Factor in inflation -- projected at 2.7% in 2007 -- and real housing prices would fall by more than 2% in 2007.
Unit labor costs are soaring, up a revised 9% in the first quarter and 4.9% in the second quarter. That's certainly enough to put the inflation fighters at the
on high alert. A few more data points like that and the Federal Reserve could decide to start hiking interest rates again after the November elections. That would take another bite out of economic growth and stock prices.
Odds Rise for Recession
No wonder the gloom is getting awfully deep these days. On Sept. 8, for example, economists at HSBC Holdings warned that the U.S. could face a recession in 2007. The U.S. economy is likely to grow -- at best -- by just 1.9% next year, the economists said, down from their earlier forecast of 2.6% growth in 2007 and their projections of 3.5% growth in 2006.
These economists are only marginally more pessimistic than the group surveyed by the
. On average, these 48 economists are calling for economic growth in the U.S. to drop to an average of 2.5% for the last two quarters of 2006 and the first two quarters of 2007. That would be a significant drop from the average growth of 3.5% over the past four quarters.
And they put the odds of a recession in 2007, on average, at about 26%. That's a big jump from last spring, when this survey put the odds of a recession in 2007 at just 15%.
Economists: Oil Prices Will Drop
But before you decide to jump under the next bandwagon and end it all, consider this part of the
Wall Street Journal
survey as well: These economists are also projecting oil at $63.91 a barrel -- way down from the $70 to $80 range that marked the top in 2006 -- in June 2007.
That's not a huge decline from the Sept. 8 close at $66.25, but a slide to $64 by June would mark a huge change from expectations that oil was set to climb without a pause straight to $100 a barrel and beyond. A shift in that expectation, even if the change in the actual price of a barrel of oil isn't all that much from current levels, would have huge effects for the stock market and the economy.
The last month has given investors a lot of evidence of how a modest pullback in oil prices can fuel a stock market rally. For example, on Sept. 8, the $1.07 drop in the price of a barrel of oil (for October delivery) to $66.25 was enough to reverse a two-day selloff and push the
Dow Jones Industrial Average
up 31 points.
And the decline in oil from $77 on Aug. 8 to recent levels was enough to propel the
S&P 500 Index
to a 3% gain for the month and to sustain the market's rally into the historically weak last two weeks of August. The S&P 500 climbed 1% during that period.
A Domino Effect
Gross domestic product numbers don't react that quickly to short-term changes in energy prices, but $64-a-barrel oil in June 2007 would be enough to give the economy a big boost over the course of a year. Consumers would have more to spend -- or at least not less -- thanks to lower or steady prices at the pump.
Lower fuel prices would take the pressure off profits at companies from airlines to truckers to railroads to retailers such as
. The Federal Reserve would breathe a sigh of relief, too, if energy costs stopped pushing prices upward, and Ben Bernanke and company at the Fed would be more likely to keep their fingers off the rate-increase trigger.
Sweet scenario, no? Lower oil prices keep economic growth higher than expected, keep the Federal Reserve on the sidelines and push up stock prices in 2007.
Of course, right now all we've got is a bunch of economists projecting lower oil prices for 2007.
Certainly, before I'd put any money behind a scenario like this, I'd like to see just a little bit of hard evidence. So here's why I think we're due for a pause in 2007 in the long-term run-up of global oil prices.
- Lower U.S. growth for the next few quarters and European economic growth that falls below expectations will lower demand for oil. In the developed economies, oil consumption isn't that sensitive to economic growth anymore -- oil demand grows only about one-third as fast as GDP, according to the investment researchers at Sanford Bernstein -- but with demand and supply in such tight balance currently, even a slight drop in oil consumption due to slower economic growth will make a difference.
- Substitution of coal for oil in power generation in China. In the short run, only oil could offer China a way to meet its huge surge in demand for electrical power in 2004-2005. That produced a huge surge in China's demand for oil, up 14% in 2004. (The winter of 2004 was colder than normal in the Northern Hemisphere, and that added to the big jump in oil demand that year.) The country has abundant supplies of cheaper and environmentally dirtier coal, but China's transportation system simply wasn't capable in the short term of getting the coal to power plants. Since the worst days of the crisis, China has upgraded its transportation and utility systems, and the country is using less oil and more coal to generate electricity. China's demand for oil isn't going fall; it just isn't going to climb as fast as it did in 2004 and 2005 and will most likely match its growth in GDP going forward.
- The continued European shift from gasoline to more efficient vehicles burning diesel fuels and the recent market shift in the U.S. toward slightly more fuel-efficient cars instead of SUVs and trucks will reduce global oil consumption marginally.
- A gradual increase in global oil production will be sufficient to gradually put a little breathing room between supply and demand. Part of the huge run-up in oil prices was due to the lack of any global spare-production capacity. Any increase in demand increased fears that some customers would have to go without. And those fears led customers to be willing to pay larger and larger premiums to assure themselves of supply. The lack of global spare-production capacity was a result of underinvestment in the oil industry in the 1990s.
The higher prices of recent years have reversed that trend, and oil companies increased their capital budgets. Many of the new projects are relatively small, high-cost efforts that are only viable with oil north of $40 a barrel. But they should be enough, estimates Sanford Bernstein, to restore spare capacity to something like a normal 3% to 4% of demand instead of the recent crisis levels of 1% to 2%.
None of this, mind you, will be enough to take oil prices back to anything like the 20-year average of $27 a barrel. Prices north of $40 a barrel are here to stay. And I think that it's likely that in a decade we will all look back with nostalgia at the good old days of $50-a-barrel oil.
But that's the long term. (And that's why I think energy stocks are the best long-term investment.)
In the short term, though, I think we could well see a lull -- not a big pullback -- in energy prices. That would be good news for a U.S. economy facing serious challenges in 2007. It would be good news for consumers, who could certainly use a break from relentlessly rising energy prices. And it would be good news for stocks.
Transportation, Energy Could Profit
I'm not yet ready to commit money to a lower-oil-prices-in-2007 scenario, but I can tell you where I'll be looking for potential candidates to profit from such a scenario:
- Airlines stocks would offer the biggest bang for a falling-oil-prices buck (and the most risk if oil prices rise) because their costs are so closely tied to the price of jet fuel.
- Trucking stocks offer a more balanced combination of risk and reward.
- Railroad stocks are a relatively low-risk way to play this scenario because they are likely to keep collecting fuel surcharges even when the price of fuel falls.
- Oil and gas producers will keep generating rivers of cash, even at $60 a barrel, so I don't see any reason for investors to abandon long-term bets in the sector. In this scenario, shares of oil and gas companies that are adding reserves and growing production, however, are likely to do relatively better than shares of those that have been solely riding the appreciation of already discovered assets.
- Finally, because oil and gas companies will still generate substantial cash flow, I'd expect they will continue to invest in capital projects that increase reserves and production, or that deliver supplies to underserved end markets. Energy infrastructure companies, in other words, will do surprisingly well even if oil prices take a pause in 2007.
At the time of publication, Jubak did not own or control any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;
to send him an email.