“Oil & Inflation”
By Arthur N. Budge, Jr.
Many investors are concerned about the prospect of future inflation. The unprecedented level of deficit spending by the federal government is scary, and the options for addressing spending are politically challenging. Many advisors are suggesting that investors increase their allocation to “hard assets” such as gold, real estate and natural resources such as oil.
We are often asked about the effectiveness of oil as a “hedge against inflation” because of the high positive correlation between changes in oil prices and changes in the rate of inflation. The following chart shows how the price of oil for the past 35 years and the CPI have increased and decreased together in almost every year:
Understanding cause and effect in data such as this is important in analyzing investments. When looking at the correlation in the chart, it is not apparent which is cause and which is effect; whether the inflation is causing the rise in oil prices or the rise in oil prices is causing the inflation.
Since the1970s, the rising price of crude oil has been a major contributor to inflation. Oil prices increase when growth in demand for oil exceeds growth in supply. The price of oil is a primary cost component in most transportation fuel. Higher oil prices resulted in higher gasoline, diesel and jet fuel prices. Higher fuel prices also increases the cost of agricultural goods and of most manufactured products because of the impact on the cost of transportation of both raw materials and finished goods. Whenever the price of oil increases, expenses to most companies rise and profits fall. Businesses attempt to pass these costs on to their customers, translating into higher prices. Under these circumstances, the higher oil prices are a cause of inflation.
One could postulate that since rising demand causes oil prices to increase thus contributing to higher inflation, weak demand in a slow economy would result in lower oil prices. However, if the concern about inflation is because of government policy such as an excessive expansion of the money supply as opposed to a strong economy causing an increase in oil demand, one might question the effectiveness of oil as a hedge against inflation. If oil were a domestic commodity, as is the case with natural gas, a stagnant domestic economy might depress oil prices. But oil is an international commodity and is priced on the international market. Because it is so transportable, producers can ship it to the highest bidder anywhere in the world.
Inflation is insidious. Not only does it weaken the buying power of our money at home, it also weakens it on the international market. If the United States has higher inflation than other countries, the value of the dollar will decline compared to other currencies. If the value of the dollar erodes, oil will become “cheaper” to foreign consumers when the price is translated into their local currencies. As an illustration, if the exchange rate between the Euro and the U.S. Dollar increases from $1.35 / €1.00 (the current exchange rate) to $1.40 / €1.00, the cost of oil per barrel when translated into Euro would drop by 4%. This lower price could then stimulate demand in Europe, pushing world oil prices higher. This could then further contribute to the U.S. inflation rate.
The recovery of the U.S. economy may well be slow, but many emerging economies may continue to grow at a fairly robust rate. Continued growing demand from emerging markets could support world oil prices. A declining dollar may also support oil prices. It is my personal view that the fact that oil is an international commodity should make oil investments a good hedge against a weak U.S. dollar and U.S. inflation, even with a weak U.S. economy. And unlike gold, producing oil properties provide attractive current income, while also acting as a hedge against disasters such as war or political instability in the Middle East. That is why I continue to believe that that producing oil properties fulfill a unique role in building an efficiently diversified investment portfolio and why I believe that most portfolios are under allocated to oil production. This is why the producing oil properties will continue to constitute the largest sector in my own portfolio.