By James Flanagan,
Los Angeles, CA, U.S.A.

mike[at]gannglobal.com
http://www.gannglobal.com/

After generally rallying for the last 2 or 3 months, stocks suddenly ran into an unexpected roadblock. The Dow Jones Industrial Average (DJIA) had climbed to within about 6% of its all-time high and other indexes, while not as close to peak historical levels, had risen in tandem. Then some disquieting news from the Middle East rocked the markets and threatened to send energy prices spiraling out of control, hammering stocks sharply lower.

Such was the situation in October 1973, at the beginning of the Arab oil embargo.  The price of crude would quadruple over the next several months, plunging world economies into deep recession. The Dow got slammed for a 20% loss by early December, and Wall Street didn't bottom until about a year later.

By Friday, January 20 of this year, stock investors wondered if history was about to repeat. Amid strong global oil demand and already tight capacity, Iran, the second-biggest producer in the Organization of Petroleum Exporting Countries (OPEC), broke U.N. seals on its nuclear facility at Nanantz on January 10 and resumed research the rest of the world fears could lead to development of an atomic bomb. The financial community braced itself for possible sanctions or even a military confrontation that could result in an Iranian embargo or otherwise disrupt crude supplies. Meanwhile, rebels in fellow OPEC nation Nigeria attacked drilling platforms, blew up a pipeline and kidnapped oil workers, knocking out some 10% of the output from the fourth-largest supplier to the U.S. It didn't help that Osama bin Laden crawled out of the woodwork (or out of his cave) and threatened new terrorist acts against America in an audiotape aired Thursday, January 19. 

Crude oil prices, which burst from the gate to start 2006 with a vigorous one-day jump of $2.10 when Russia rekindled concerns about the use of energy as a political weapon by temporarily halting discounted exports of natural gas to now pro-western Ukraine, continued their resurgence. The expiring February contract surged $1.52 to close at $68.35 per barrel on January 20. March crude likewise shrugged off official reports of a surprising 2.7 million barrel rise to multiyear inventory highs to end the week at $68.48, within easy striking distance of the all-time cash price high of $69.81 and nearest-futures record of $70.85, both established in the immediate wake of Hurricane Katrina, which ravaged the oil-producing Gulf Coast and submerged much of New Orleans at the end of last August. The DJIA plummeted more than 213 points, or 1.96%, on heavy volume likely magnified by the expiration of January stock options, its biggest single-day slide since May 2003. The decline wiped out what was left of the blue-chip average's gain for 2006. Broader measures, although also sharply lower, remained slightly in the black on the year.

An insatiable appetite for affordable energy, and the ability of industry to deliver it through improvements in technology and distribution, has fueled the engine of economic growth since the days of the Industrial Revolution. Coal became the first fossil fuel to emerge as the nation's primary energy source when it displaced firewood in 1885, and at the end of World War I still accounted for 75% of total U.S. energy use. In the late 19^th century, America remained mired in the so-called "Long Depression," marked by deflation and protracted bear markets in stocks from 1872-1877 and 1881-1896. Business picked up, however, when the use of electricity, essentially unavailable before the 1880s, exploded by a factor of 600 between 1896 and 1912 as utility companies slashed production costs per kilowatt-hour from 12 cents to 2 cents.

Petroleum was relatively slow to catch on as a fuel in the decades following August 1859, when "Colonel" Edwin Drake, a railroad conductor on sick leave, struck oil with a 70-foot homemade drilling rig in Northwest Pennsylvania before he could receive an order from his backers to quit. Auto production, in units, finally surpassed wagons and buggies for the first time in 1913.  The U.S. population of draft animals, such as horses and mules, didn't peak until about 1920. Car sales tripled during the Roaring Twenties, and only the Great Depression could interrupt the boom in consumption of crude. 

After World War II, railroads lost business to trucks and began switching to diesel locomotives themselves. Simultaneously, labor problems and safety requirements pushed up coal production costs. By 1947, petroleum consumption exceeded coal. U.S. refiners never paid more than about $3 a barrel for oil. To protect domestic producers, President Eisenhower instituted import quotas in 1959 under the Mandatory Oil Import Program (MOIP), resulting in a stable U.S. price around $3 that persisted until 1970. Even at the paltry $3 level, American consumers effectively subsidized the oil companies by paying significantly more than the rest of the world. The price of Arabian light crude, as posted at Ras Tanura, a city in eastern Saudi Arabia, stayed at $1.80 per barrel in the 10 years following the formation of OPEC in September 1960. 

Dirt-cheap energy prices ushered in an unprecedented "Golden Era of Economic Growth" in Western Europe that saw a 5% average annual expansion in real Gross Domestic Product (GDP) in the west, including the U.S., and near-10% growth in Japan from 1950 to 1973. Increasingly prosperous Americans fell in love with a wide assortment of electric appliances and gas-guzzling vehicles.  After supplanting coal as the nation's main fuel source, oil consumption quadrupled in a generation. Never has an energy source achieved such rapid dominance. By comparison, it took 38 years for overall domestic energy consumption to quadruple in the 1880-1918 period. Between 1930 and 1970, the real (inflation-adjusted) price of gasoline dropped by over 70%. From 1940 to 1970, the real cost of electricity per kilowatt-hour fell more than 75%. Per capita electricity consumption rocketed by 8 times during the 1940-73 interval. Predictably, given the glut of power, nobody cared much about energy efficiency. A doubling of GDP, which required a 150% increase in electricity usage before the end of the war, suddenly necessitated a fivefold escalation.

Americans had power to burn, so they did. But burgeoning domestic demand outstripped production, forcing the U.S., which had remained largely self-sufficient in energy through most of the 1950s, to import enlarging quantities of crude oil. By 1976, foreign oil accounted for fully half the nation's usage. Making matters worse, aggregate U.S. petroleum production topped in 1970 and then began to tumble, as correctly forecast by Dr. M. King Hubbert, a geophysicist who created a mathematical model to predict maximum output ("Hubbert's Peak"), which is eventually supposed to lead to a steep decline once depletion ensues. Needless to say, Hubbert's theories have drawn renewed interest in an environment of record-high oil prices.

All of this left the U.S and other oil-importing countries extremely vulnerable in 1973 when indignant Arab oil exporters retaliated against the west for backing Israel after Syria and Egypt attacked it in the Yom Kippur War. The era of robust economic growth quickly gave way to a decade of stagflation and stratospheric interest rates, punctuated by the 2 worst postwar recessions to date and a stock market that couldn't get out of its own way. Surprisingly, neither the original embargo nor a second "energy crisis" sparked by the Iranian Revolution in 1979 and subsequent outbreak of the Iran-Iraq War in 1980, nor any other worrisome geopolitical events since have prompted the U.S. to particularly lessen its dependence on foreign crude. Between 1985 and 2000, imports more than doubled. Starting in 1994, U.S. imports exceeded domestic petroleum production and total net imports hit a record 52% of consumption in 2000.

Most Wall Street analysts noted abundance in storage and supplies before projecting subdued oil prices averaging about $55-$60 in 2006, on the heels of last year's greater-than-40% leap to $61.04 a barrel at the end of 2005. Can the stock market and economy survive prices at current levels or higher?

Of course, they may not need to. The rampant bullish trend in crude dates back to at least November 15, 2001, when oil stood at $17.48 a barrel, placing it in a very mature position for a cyclical bull market in any commodity. Oil's frenzied move up when Hurricane Katrina struck looked climactic but, though prices sagged, they hung on stubbornly. The present strength in commodities as a whole appears powerful enough to possibly overwhelm any factors that might otherwise dampen the advance. Metals prices are going through the roof and the Continuous Commodity Index (the old CRB Index) recently made fresh all-time highs, although its breakout remains unconfirmed by the energy-heavy Goldman Sachs Commodity Index, which still languishes beneath its post-Katrina highs.

Even if crude manages to prolong its uptrend, it need not spell the end for stocks. The entire bull market since October 2002 unfolded even as oil prices spiked more than 100% higher. The economy remained remarkably unfazed by last summer's destructive hurricanes and tumult in the energy markets. Emerging economies are supposedly more sensitive to oil shocks because they use far more energy per unit of GDP than their counterparts in the developed world, but the change in year-over-year GDP currently averages 5.5% for 25 of the top emerging markets in the face of crude prices well above $60. 

In the U.S., the oil crises motivated Americans to become more energy-efficient.  Energy outlays decreased as a proportion of household expenditures from a peak of 9.3% at the height of the 1980 crisis to a more manageable 6.3% at its most onerous level post-Katrina. The energy consumption needed to produce a constant dollar's worth of GDP got cut virtually in half between 1949 and 2000, although the rate of decline moderated somewhat after crude prices fell off the table in 1986. Vehicular fuel consumption also decreased markedly after the embargo, until fuel economy began to level off in the 1990s. And while Americans can't seem to kick the foreign oil habit, at least the share of U.S. net imports from OPEC nations slipped to less than 44% in 2004 compared to a whopping 72% in 1977.

High prices so far haven't killed America's taste for black gold. U.S. consumption recently crossed 22 million barrels per day to set a new record. Historically, rising crude prices only launch bear markets and recessions when they go up enough to drive down consumption. A short-lived slowdown in demand appeared to materialize last autumn when gasoline pump prices vaulted past $3 a gallon, but it usually takes something quite drastic and stunning to inflict lasting harm. The 300% embargo-related price spike in a span of roughly 5 months in 1973-74 certainly qualifies, and its lingering effect suppressed consumption into 1975. Demand recovered by 1978, but slumped to a post-embargo low in 1983 on Middle Eastern turmoil and recessions stateside. A furious 164% price jump in less than 4 months caused by Saddam Hussein's invasion of Kuwait in August 1990 led to a slight dip in oil imports and a brief recession.

A study of every major bull market top in stocks dating back to the Civil War reveals that important highs in bond prices (lows in interest rates) preceded each big-time downturn in the stock market except for a handful of occasions, in which the turn lower in bonds slightly lagged or occurred coincident to stocks. Commencing with the 1973 Arab oil embargo, crude prices and long-term interest rates tracked one another with uncanny correlation for over 2 decades. It's not all that surprising when you consider that prices for money and the planet's most critical commodity each respond to similar economic forces like growth rates and inflation. A temporary feint higher by interest rates in 1983-84 marked the lone instance when a change in one market's direction didn't pull the other along within a reasonable time frame. Long rates ratcheted up from below 7% to above 8-1/2% in 1974. After a few years of relatively flat prices, crude went nuts in 1979-80. Bonds embarked on a secular bull market after long rates skyrocketed well into the teens in 1981. In the meantime, oil prices stayed weak for 18 years. Both interest rates and crude collapsed in late 1985-early 1986. Bonds topped less than 2-1/2 weeks later than crude's bottom in the spring of 1986. Interest rates then sprinted higher with oil until July 1987 and bond investors got no relief for another 3 months, when Wall Street's precipitous Black Monday bloodbath induced a flight to safety and caused central banks around the world to flood financial markets with liquidity. Ten-year Treasury yields topped out in May 1990 and challenged their highs again in August following the Kuwaiti invasion. Oil peaked just weeks later on the same day that stocks descended to their final bear market low. On October 5, 1998, bonds established an important high.  Though hard to believe, crude started its historic ascent soon thereafter, from a low of a mere $10.80 a barrel in the week before Christmas of 1998.  Stocks would reach highs not seen ever since in the first quarter of 2000. 

Bonds haven't reacted at all to crude's latest bounce. Interesest rates on 30-year Treasuries hit rock bottom at 4.135% in June of 2003 before retesting that level 2 years later. They're still hanging around within hailing distance, less than 50 basis points (hundredths of a per cent) higher.  It would be all but unheard of for a bull market in stocks to endure for over 2-1/2 years following a bond-price peak, assuming 2003 marked a concluding bond top. Lead times in the past have typically approached 2 years at most.

Before high oil prices can terminate the bull market in stocks, they'll probably have to put a meaningful dent in the bond market or impact consumer demand for energy, which seems unlikely given that heating oil is lagging crude noticeably and natural gas prices just skidded to a 7-1/2-month low on unseasonably mild winter temperatures. Friday's sharp stock sell-off engendered a fair amount of pessimism among option buyers, and the S&P just barely clipped its important August 2005 high on the first trading day of this year, before reversing sharply higher, which should bode well for stocks going forward.

About the author:

James Flanagan is a well known specialist in the field of financial market forecasting and analysis. Using a proprietary, complete database of price history and the methods of W.D. Gann, he has been publishing his forecasts and investment research since 1990 (Past Present Futures newsletter). James oversees all of the research for the Financial, Stock, and Commodity Markets at Gann Global Financial. You can visit his website: http://www.gannglobal.com 

Published - February 2006