< Back to Iraqi Dinar in the News October 31st, 2007

The new math of oil

The new math of oil

High energy prices are always bad, right? Not necessarily, says Fortune's Geoff Colvin.

By , Fortune senior editor-at-large

(Fortune Magazine) -- We're hard-wired to tremble when oil prices rocket, and the past few weeks have looked like another example of why. Whenever stocks fell sharply, as they did several times, traders blamed the fast-rising price of oil.

But that chain of logic is misleading. The bigger picture shows that the relation between oil and the economy is changing, and we'll have to rewire our brains to understand what's happening. Watching oil prices rise and fall is no longer enough; the key now is understanding why they're moving.

You know something strange is going on when you step back and examine the stock market's performance not of the past three weeks but of the past five years. As oil prices have surged, they haven't knocked down stocks or hobbled the economy. Instead just the opposite has happened: Oil has tripled, yet stocks have roared ahead to new records, and the U.S. economy has grown smartly over the whole period. That is not how things work, or so we learned after oil spikes triggered recessions in 1973, 1980, 1981, and 1990.

The critical insight into what's happening comes from Daniel Yergin, chairman of Cambridge Energy Research Associates and a longtime authority on world energy. "This is a demand shock, not a supply shock," he says. "What's causing it is the extraordinary economic growth of the past few years."

Previous oil spikes happened when OPEC closed the spigots; the resulting high prices were a tax on the world economy and slowed everything down. But today's situation is the opposite: Strong global economic growth is pushing oil prices up. As Yergin puts it, "The economy is having a greater impact on oil prices than oil prices are having on the economy."

Of course demand isn't the only factor pushing oil up, as Yergin and every other analyst understands. The price rise of the past few weeks, from the high 70s to the high 80s, seems clearly a result of fear that supplies will be disrupted by a possible Turkish incursion into northern Iraq or some kind of crisis with Iran. That makes this latest rise an old-fashioned supply shock, or rather a fear of one, which is why it has hammered the markets.

But the fear factor is responsible for only part of today's high price. The real culprit is broadly growing global demand. We're in the midst of a virtually unprecedented period in which nearly every major nation's economy has been expanding. So to figure out how we feel about rising oil prices, we must now ask why they're rising. If they're caused by constricted supply, they'll probably trigger bad news, like a recession. But if they're caused by strong demand, they're probably the result of good news, a growing world economy.

Here's one more part of the puzzle: Markets clearly expect the price of oil to decline. Specifically, crude oil futures reflect a price that falls further for each additional month they extend. In addition, the stock prices of Exxon Mobil (Charts, Fortune 500), Chevron (Charts, Fortune 500), ConocoPhillips (Charts, Fortune 500), and other giant producers reflect investors' expectations of falling oil prices.

If you take the profits of these companies over the past four quarters and capitalize those profits at the appropriate capital cost, you get what each firm would be worth if it were to continue cranking out the past year's profits every year. But in each case the company's actual market value is lower; that is, the market expects each company's profits to fall, for which the only plausible explanation would be declining oil prices.

Now for a real-world test of our new mental wiring: Should we be cheering or crying over the fact that prices are likely to head lower? A decline of 10% or a bit more, assuming it reflected vaporization of the recent fear premium, would certainly be good.

Beyond that, we can expect downward price pressure from basic, predictable economic forces: increased supply induced by today's high prices, though bringing it online takes a while, and substitution as alternative energy sources start to make sense vs. expensive oil. More downward pressure will come from the world economy continuing to become less energy intensive, producing more GDP per barrel. That's all good.

But we need to remember that recessions in some or all of the world's major economies would also bring oil prices down. So if the market is right and prices do fall, let's check our instinct to cheer and first ask why. It's possible that in today's economy, a declining price of oil could truly be cause to tremble.