Knowledge@Wharton Finance and Investment Research Article

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Memorial Day, which marks the beginning of the summer driving season in the U.S., saw gas prices at nearly $4 a gallon all over the country -- and even higher in states such as Florida. Globally, the picture looks more worrisome: Oil prices crossed a record $135 a barrel during the weekend of May 24-25, although by Tuesday prices had come down to $131. What's behind these regular flare-ups in oil prices? What are the major economic and geopolitical factors at work? How does expensive oil affect the U.S. and world markets, and what can we expect over the coming months? Knowledge@Wharton discussed these questions and more with finance professor Jeremy Siegel, author of The Future for Investors, and management professor Witold Henisz.

An edited transcript of the conversation appears below.

Knowledge@Wharton: As we know, oil prices jumped to a record $135 a barrel during this past weekend. Do you think that they are near the top now? And if not, how much do you expect them to rise over the rest of the summer?

Siegel: I think that I would be presumptuous to even theorize about whether we are near the top. I don't think that anyone really knows. It's my feeling that even OPEC [Organization of the Petroleum Exporting Countries] has basically lost control of the price of oil and they're going flat out. By that I mean that they can push some more, but not easily. And, given the demands, it obviously could go much higher. I don't think anyone knows [how much]. I think that it's a guess.

Henisz: I think that a guess and a lot of uncertainty are certainly accurate. There have been discussions recently of $200 a barrel for oil. The big uncertainties are: Is there more existing capacity in the OPEC nations, can they produce it and will any one country go off line? There is a lot of uncertainty in African countries and Latin America countries about whether they can maintain their production and expand it according to existing forecasts. We simply don't know the answer to that and the traders are trading based on that uncertainty, generating the high price of oil today.

Knowledge@Wharton: A lot of people are not very sure about what the major factors are -- economical and geo-political -- that are really driving the price of oil. Could you help by explaining that a little bit for our viewers?

Henisz: We're in a period of tight balance between existing supply and demand, which is generating a lot of uncertainty about the future path of both of those variables. I think the big uncertainties that we have to grapple with are how much more capacity does Saudi Arabia have and how much can they bring online in the short term? We simply don't know. They haven't revised their existing estimates of reserves for some years -- and we simply don't know whether they are conservative estimates or whether they can be expanded. That is true in many countries throughout Africa and Latin America. We don't know what the future capacity and reserve levels are.

Siegel: Yes, and as I've mentioned, I don't think that there's an easy way to increase the supply or at least significant supply in the short run. A lot of it is economic. It's hard to blame speculators because we don't see a lot of inventory increasing in oil, which would be a sign that people are hoarding it at this point. [There is also] psychology [involved in] that everyone wants a piece of oil because they want to protect themselves against oil price increases. So, if I own some, at least I'll have something that will go up when the price of oil goes up. Well, of course, if everyone tries to do that, it's almost like "the sky is the limit." This is because I think that not everyone can protect themselves or completely immunize themselves against this oil increase and that's what the upper threat is. 

Henisz: The other side is the demand uncertainty. How much more will demand in China, India and other countries grow? The other side of the equation is also a lot of unknowns.

Knowledge@Wharton: Right. I saw that George Soros, the billionaire investor, was interviewed by one of the British papers over the weekend. He said that speculation was primarily responsible for the further rise in oil prices. But it sounds like you don't necessarily agree?

Siegel: There's a fine line between speculation and buying for an even more expensive future. I think that people realize how important it is to hold some oil producing assets in their portfolio. If everyone thinks like that -- that will go up. It's not just speculators ... moving that up. This is a scarce resource that the world is using more and more rapidly. Peak oil is always in the air and I think that is generating the increases.

Henisz: If you look at the probability that one country could go offline, driving a substantial increase in price is something that people are trading on the probability of. Is that speculation or is that hedging? When Southwest Airlines hedges their future oil supply, they are lauded as being smart relative to the rest of the airline industry. That's not speculation, that's hedging.

Knowledge@Wharton: Many of the media reports seem to make a connection between the weak dollar and the rise in the price of oil. Again, could you help explain what the connection might be?

Siegel: It's more than just the dollar going down because even if you measure it in euros, which has been one of the strongest currencies, they have had a huge increase recently. Today, we have the truckers in Britain calling for a strike because the price of gasoline is going up so high there and they can't pass on the charges quite as easily as we can. It's now a worldwide phenomenon. I mean, certainly as of a year ago, in dollar terms, we're up more than the rest of the world. But over the last three, four months and five months the increase has been so rapid that it has affected every currency.

Henisz: I agree.

Knowledge@Wharton: What effect is high oil having on inflation and the U.S. stock market and the economy more broadly?

Siegel: You know it's surprising that many economists felt that by now we would begin to see the higher oil prices move into what we call core inflation -- which is those basic goods and services that are not directly oil and energy, such as manufacturing, etc. We haven't really seen it because there has been downward pressure on home prices now. There's been some downward pressure actually on physician prices and medical prices surprisingly have been very soft over the years. This has sort of offset the increases in oil.But these recent increases in oil have been so massive and so rapid that we haven't really had time to see how they might figure into the indices. That's why I think that over the next couple of months, it's going to be really important to look at these price indices. I don't think that they're going to be as good.

Henisz: I think that there are two channels, one direct and one indirect, that are really interesting to watch. One is just the cost of transportation and that will spill over into certain goods, including food and others. And also, the indirect costs. As the price of oil keeps going up, we are starting to spend more on alternative fuels and divert efforts into renewable fuels. That is driving up the cost of agriculture. So there are both direct and indirect channels which we can foresee in the next 12 to 24 months.

Siegel: And we've seen that substitutes for oil, particularly natural gas, have gone up dramatically just over the last three months after remaining stable for many years. It did not go up with oil, but just over the last three or four months it has gone around 40% or 50%.

Knowledge@Wharton: Another thing that many Asian countries have recently announced -- for example, Taiwan, Indonesia and Malaysia -- is that they are going to get rid of all the subsidies for fuel. What impact do you see that having on both the markets and the countries themselves?

Henisz: There is a question as to whether that's credible. It was the removal of fuel subsidies that led to the downfall of Suharto in Indonesia. Whether it's really credible that they'll actually follow through on that promise, in the face of popular unrest, is a big uncertainty. I would take a step back and say whether that can actually happen before we really analyze its impact.

Siegel: Although it's certainly more expensive now to maintain pricelids.And it might be that some of these governments don't have money ... to be able to buy at the world price, if they are importers, and then subsidize it down to the level that they had been in the past. So it could provoke a lot of unrest even if the government had wanted to keep the prices lower.

Knowledge@Wharton: Turning now to the U.S. economy, home prices fell in 20 U.S. metropolitan areas in March. The Case Shiller Index fell 14% compared with the level a year ago. Do you see any silver lining at all in the housing market, or will the downturn continue for the foreseeable future?

Siegel: Well, the good news is that if you didn't own a home and you were intending to buy one, you're getting a potentially good deal out there ... if you had been renting for instance and waiting for the prices to go down. Also, for those people who wanted to upsize their home, that were planning to do this and waited. The people who have lost, of course, are the people who have bought in the last two to three years, at the peak. And that's what we are worried about because many of them are underwater with the threat of foreclosure and so on. That's been a very major depressing point. So it really depends on what position you're in. There are silver linings for some people but certainly not for all. 

Knowledge@Wharton: More economic indicators are scheduled to be announced this week, ranging from new home sales to consumer confidence, and also a few others.

Siegel: We actually got the Consumer Confidence Index today and it was not good. I think that it was another 15 to 16 year low. This is the Conference Board that comes out on the last Tuesday of every month. We got that at 10 a.m. and it was another downtick. I mean, the double whammy of the home prices and the rising price of oil is weighing on the psychology. And you know all of the surveys show near record consumer dissatisfaction.

Knowledge@Wharton: Based on what you have just said, what's your prognosis for where the economy as a whole is going and what we can expect to see?

Siegel: I just did some kind of 'back of the envelope' type of calculations and it was pretty sobering. We import about 12 million barrels of oil a day, and at $130 a barrel -- no one knows if it is going to stay there; it could go higher or lower -- that's about 4% of GDP, almost $600 billion. That's doubled over the last year. First oil was occupying 2% and now it's gone to 4%.... And given that productivity is up on the average, around two years of GDP, this whole process so far would cost a whole year's productivity gain into the U.S. economy.

Now with that said, it still seems like we're muddling along above zero. Our quarter is two months over and most people are still staying that this is going to be a positive quarter, just like the last one was, too. It is nothing great, but nothing negative the way that you would think of in a recession.

Henisz: I'd like to end where we started, a little bit, in thinking about the uncertainties. The impact so far has been substantial, but we're still above zero. There are uncertainties as to whether the credit crunch spills into auto loans, as was reported this morning, or spills into other highly leveraged debt; whether the oil price affects food prices, such as already mentioned; whether it leads to other spill-over effects in instability in Africa and instability in Asia. These are things that we can't foresee and that could really cause something devastating in the coming months.

Knowledge@Wharton: What are the key geopolitical risks that you are most concerned about, if this economic situation continues?

Henisz: Well, under the current circumstances, any attack which would impact the supply of oil would have devastating consequences. An attack in the Spratley Islands, an attack in the Gulf region, an attack on a refinery - we just don't have the spare capacity in the short term. So we're really at risk of any break in the supply chain.

Siegel: Are you talking about terrorist attacks when you are referring to that?

Henisz: Yes.

Knowledge@Wharton: Just this morning, I think there was a report that an attack in Nigeria was responsible for an uptick in the price of oil.

Henisz: Yes, some of the hopes about the price of oil falling -- [Warren] Buffett called it a "bubble" recently -- were on the back of Nigeria's supply, them coming back online under Shell and others. But, we can't be sure that's actually going to happen. So, yes I really think that those uncertainties are paramount on the geopolitical front.

Siegel: It seems like every time we say, "Oh, the price went up because of this, this and that" and then that thing disappears and the price still goes up. So, there's got to be many more forces than some of the commonly-used phrases and explanations for that. I think that deep-seated increases in demand, deep-seated hedging, real hedging against that uncertainty and a relatively fixed short term supply -- are just fueling this increase.

Knowledge@Wharton: To end with a variation of the question that we usually ask -- which is "What should be the strategy for investors going forward" -- this time I'd like to ask, what should investors and oil consumers be doing going forward?

Siegel: Let me comment a little bit on the investors, because I follow that area pretty closely. I still claim that this is a market that would want to go up if it wasn't being hit over the head with oil and the ever increasing price of it. This is because that is a big chunk, as a major world importer of oil. If there could be some stability here -- or if we could get back down to $100 a barrel and just stay there -- I think that we would see the market up 15% from where it is, because you can just see the way it wants to go up and then oil, oil, oil. But if oil continues at this rate or continues to rise, it's going to be hard [going] in the market. It's not a panic, not a real sell or a sell-off, but it's going to be tougher for equity investors in the short run. 

Knowledge@Wharton: Witold, any final comments?

Henisz: No, I defer to Jeremy on the broader macro questions.

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