September 2008: by Dale R. Berg

Oil prices may impact other market fluctuations

As Canadians, we need to understand the close connection our economy has to the price of oil. There has been substantial discussion, concern, and interest lately attached to the price fluctuations of oil.

Currently, the energy component of the U.S. Consumer price index is up 29 per cent year over year. Looking back to 1972, oil averaged US$3.39 per barrel, and from 1972 to early 1981 oil rose 11 1⁄2 times to US$39 per barrel. But what is interesting is what happened during that time frame to inflation. Inflation in 1972 was 4.9 per cent, and inflation in 1981 was 12.9 per cent.

Lately we have seen a similar increase in the price of oil over the last 10 years. In December of 1998 the price of a barrel of oil was US$10.35, on July 11th 2008 oil was trading at $147.27 per barrel. That equates to 14 times over the last 10-year period, yet inflation in 1998 was 1 per cent and in June of 2008 inflation stood at 3.1 per cent. What this means is we generate twice as much economic output now per barrel than we did in 1972, and individuals are actually scaling back consumption of gasoline in response to higher fuel prices. It's a very interesting observation on price fluctuations and consumer discretion.

What's more interesting as a Canadian, and a Canadian investor is how closely related the Canadian equity market is tied to the price of oil. Canada's stock market has been a world leader in world equity market performance since the early 2000's thanks to its heavy weighting in resources.

As mentioned earlier, oil hit an all time high on July 11th of US$147 per barrel with many energy analysts speculating oil to go well over the US$150 per barrel. What recently occurred was by August 8th oils closing price was US$115 and during that price for crude decline, the TSX lost 8 per cent. According to the Organization of Petroleum Exporting Countries (OPEC) oil at that level is 44 per cent higher than what its fair market value is to be based on current supply and demand factors.

The question an investor now needs to ask is, if the price of oil, and the Canadian stock market are closely correlated, and OPEC states the price of oil is 44 per cent over valued based on supply and demand, what might that mean to the TSX?

Another Canadian economic item very closely tied to the price of oil is the value of Canadian Currency. The graphs for the price of oil mirror the value of the Canadian dollar. The same question can then be asked, if the price of oil, and the value of the loonie are closely correlated, and OPEC states the price of oil is 44 per cent overvalued based on supply and demand, what might that mean to the future value of the Loonie?

What we need to know as an investor is in the short term, commodity prices, and stock prices are based on fear and greed. Accurately predicting the price of oil, or any other commodity is virtually impossible, and many speculators have tried and failed horribly. Geopolitical events, natural disasters, wars, and terrorist attacks will all play a very important role in effecting the price of crude.

Over the long term though, as these outside factors will drive the price higher in the short term, a longer-term view is what investors should focus on. A slowing of the world's economies and a reduction in consumer consumption will serve to moderate the demand for oil. Alternative fuels such as fuel cells and hybrid vehicles will also erode demand. As demand is curtailed, it stands to economic reason that prices for crude will decline.

So as a Canadian investor, what should you do? It's not a very exciting answer, but stay diversified, own equities around the world including the US, Europe, and emerging markets.

Most importantly, do not chase returns, talk to your financial advisor and make sure your portfolio is not concentrated to heavily in one sector, or in one particular countries equity market. There are current opportunities to achieve future returns, and your advisor will point you in the right direction.

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About the author
Dale R. Berg, CFP, CLU, ChFC, is a Senior Financial Advisor with Regency Advisory Corporation. He can be reached at 1-877-837-3377 or 306-665-3377, or click to email Dale Berg.

Disclaimer
Please contact a professional advisor to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.

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