Kass: Cheaper Oil's Silver Lining

This column originally appeared on Real Money Pro at 8:47 a.m. EDT on April 16.

NEW YORK ( Real Money) -- Yesterday I outlined the bearish case for equities in my opening missive. I extracted multiple concerns into one big one:

If we distill my multiple concerns into one concern, it is the more difficult earnings backdrop that should become increasingly apparent to market participants in the near term. Given that the growth in nominal U.S. GDP is trending at under 4%, corporations have little in the way of pricing power. And with profit margins at all-time highs and nearly 70% above the mean levels achieved in the last seven decades, earnings forecasts are threatened based on slowing top-line growth and a likely mean reversion in margins.

Later in the day I also highlighted four important divergences (oil prices, gold prices, the EUR/USD cross and the 10-year yield) with the S&P 500 that suggested that the U.S. stock market would likely catch up with the other declines.

The drop of some of those four variables is likely a function of a downward recalibration of global growth expectations over the past month.

There is, however, a potential silver lining to lower oil and other commodities prices that I wanted to examine this morning. (Note: Yesterday, the two most commonly followed commodity price indices dropped by over 2.5%, led by a 7-8 standard deviation drop in precious and base metal prices.)

To date, as Jim Cramer has recently pointed out, the broad decline in commodities (e.g., oil prices) has created a bubble in safety -- namely, in stocks such as Procter & Gamble ( PG), PepsiCo ( PEP), Clorox ( CLX), Coca-Cola ( KO), Colgate-Palmolive ( CL). I own several of these bubblicious defensive consumer staples stocks that have, owing to a near parabolic share price move, become offensive in certain ways.

As of the end of last week, more than 70 consumer stocks made 52-week highs on the NYSE. I have tracked data on this subject personally for over 20 years, and this is a very strong number, easily in the 98th percentile of over 1,000 observations. This is a very broad market move in the defensive sector despite all the angst generated by the press, the E.U., North Korea and Washington, D.C. I sense something of significance may be happening that is not being watched closely. If I am right, a new up-leg in economic growth is possible later in the year, which could partially deflect my fears of a recession ( expressed in yesterday's opener).

My background is in finance and economics.

The dismal science has laws, but they get broken. The first you learn is the law of supply and demand. Since 1973, it has not functioned well in oil markets. Another law is that, in the fullness of time, cartels eventually do not work. That law also has not functioned well, as OPEC has survived over several generations.

As you read this, keep in mind that I am not an oil economist (nor am I even a decent investor in oil-related equities). As a sometime consumer specialist, however, I have had to observe oil prices and understand their impact on consumer behavior.

Nothing impacts consumer spending faster than change in price at the gas pump.

In 1973, OPEC announced its oil embargo, and the price of crude tripled. For almost 40 years, oil prices have included an oligopoly rent from OPEC (also called political uncertainty), which has trumped the law of supply and demand.

The cartel's influence may now be finally breaking down.

Today, with WTI down to $88 a barrel, gas prices are below year-ago levels, serving to provide the consumer with a tax cut. Chinese demand is ebbing, perhaps due to concern about horrendous pollution. Cars are growing more fuel-efficient. Plus, there are other, larger factors at work:

  • New supply is developing due to the fracking boom that has increased supply of U.S. crude as well as natural gas. The collapse in price of tankers ($170,000 a day at peak to $7,000 a day now) confirms that less oil is being transported globally.
  • Several producers of oil are now in a mode of having to produce. This includes Russia, Saudi Arabia (which must support a growing welfare state for its youth), Iran (where a lot of its oil is embargoed), Iraq (which needs cash) and Venezuela (which also needs cash). Indeed, it is hard to find a member of OPEC that is not motivated to produce.
  • Commodity investors have had a boom in the last 15 years. That may be ending. Gold is in a bear market. Gold investors may be getting margin calls forcing them to liquidate other commodity pools (which have huge weightings to oil). This creates a vicious cycle, forcing oil and other commodities down. (In just the past two weeks, commodity indices used at The Economist are down by over 7%. That may not seem like a lot unless you have 5x margin, which you can in some of these contracts.)

Oil is still far above the point of zero marginal production price. The price of crude might have a lot further to go, and, in the short run, prices can go below the cost of production.

The law of supply and demand may start to apply to oil, and OPEC may be all over. Both, at least in the intermediate term, would be bullish for the U.S. economy -- the consumer sector will be delivered with a tax cut and corporations' profit margins could be buoyed. It could also be seen as a negative for the bond markets as lower commodities revive economic growth.

There is a silver lining.
At the time of publication, Kass and/or his funds were long TBT, PG, PEP and CL, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.