Is Oil the Game Changer?

By Josh Lipton Oil prices are soaring amid the continued violent political turmoil in Libya, with economists now debating how much of a risk such a spike poses to this nascent US economic recovery. Strategists rattle off the headline-making litany of unknowns emanating from the civil unrest spreading across the Arab world: will secular autocrat regimes now simply be replaced by religious autocratic ones? Will unrest spread to Saudi Arabia, which holds 20% of the world's oil? How will Israel respond as Iran now uses the Suez Canal to ferry warships to Syria?

To read Quint Tatro's piece on four momentum names and what they reveal about recent sell-offs, click here.)

In short, there are many unknowns. But here is one certainty: the threat of a breakdown in civil society in much of the Middle East has sent oil prices surging. This morning, West Texas Intermediate (WTI) -- the benchmark for US oil prices -- is at $96.93 a barrel while Brent Crude -- the benchmark for oil prices in Europe, Africa and the Middle East -- is at $111.20 a barrel. Energy prices remain extremely volatile, first surging yesterday to a 29-month high and then pulling back as Saudi Arabian officials said that the world has enough oil on hand to replace production lost to Libyan unrest, and unconfirmed rumors circulated about Colonel Muammar el-Qaddafi's death.

(To read Justin Rohrlich's article on investing in the modern battlefield, click here.)

Still, oil is now headed for its biggest weekly gain in two years. Since the beginning of the year, oil prices have risen 5.7% while gasoline futures have jumped 11.4%, according to Bloomberg data. A concern has been that the political unrest in the Middle East and North Africa would disrupt the world's oil supplies, leading to a sustained spike in the price of the black gold. This has the financial markets worried about an energy-induced slowing of the economy and for good reason: economists note that, in the past, rising oil prices have been associated with sharp slowdowns in growth. In fact, every recession since 1973 either has been preceded by or coincided with a sharp rise in oil prices. David Kotok, the chairman and chief investment officer of New Jersey-based Cumberland Advisors, which manages $1.5 billion in separately managed accounts, says that the risk of recession is rising daily:

(To see Todd Harrison's thoughts on critical market junctures, click here.)

"The risk rises with an energy shock and higher gasoline price, which piles on top of a fragile recovery,” Kotok says. “The last time we had such an energy shock, we had rising house prices. So there was an impact on the consumer, but the consumer could borrow against his house. This time, he can't."

In terms of investment implications, Kotok says that he is now maintaining high cash reserves and a major overweighting in the oil and energy sectors through various exchange-traded funds. One well known ETF investors use for such purposes is the Energy Select Sector SPDR (XLE), which includes holdings like ExxonMobil (XOM), Chevron (CVX), Schlumberger (SLB), ConocoPhillips (COP), and Occidental Petroleum (OXY). Kotok also points out that, for every penny increase in the cost of gas, US consumers pay an extra $1.2 billion a year. “Every penny increase in the gas price is like a sales tax on the consumer,” the strategist says, which is one reason he remains underweight the consumer discretionary sector. David Rosenberg, Gluskin Sheff's chief economist and strategist, believes we are getting closer to the point where the surge in oil prices could tip the global economy back into recession. He says that, over the past 40 years, there has been a double-digit run-up in both fuel and food prices at the same time in only three instances.

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