Crude Oil: It's effect on stocks and the economy

Stocks are beginning to run out of steam thanks to oil hitting records nearly every day. Everyone thought, including me for a while, that the dollar’s rally (thanks to the Federal Reserve’s intervention March 17^th with Bear Stearns) would cause crude prices to slip, but that hasn’t been the case. For the longest time, the dollar’s decline fueled crude’s rally. However, oil has become completely decoupled (independent) from the dollar trade.

Everyday last week crude oil – and prices at the pump – hit another new all-time high. Everyone is now concerned that the consumer is going to stop spending with gas at $4 and expected to increase. You know when stock prices are overextended and people are worried when the major oil service stocks sold-off towards the end of the week. These are the companies that directly benefit from higher oil prices so they should not have gone down.

Some analysts on CNBC were saying that high prices will be the cure for high prices; that is, as oil goes higher demand will decrease driving prices down – or at least stabilizing them. But that analysis is flawed. People need to drive and they will pay for gas. Yes, people may cut back on the road trips and vacations and other amenities, but it won’t slow down oil’s run to $150 and beyond. What’s going to get hurt from higher oil prices besides everyone’s wallet? It will be the retailers and other big ticket item makers.

If you think oil is going higher, which I think it is, then one possible trade for the next few months is to go long oil (USO) or the oil service stocks and short the stock market (SPY). Another trade is to look at natural gas or the natural gas exploration/drilling companies. As crude prices continue to skyrocket, companies are looking for alternative energy sources and natural gas is an already proven source that is becoming more and more popular.

Many experts think oil prices will decline soon – back to about $100 by the end of the year. There is the argument that the fundamentals (global supply and demand) don’t support the current prices levels and that speculators are driving up prices. This has been the argument for the last 9 months and if you went with this thesis, you would have lost tons of money as oil went from $50 (Jan ’07) to $125. This last week everyone has become extremely cautious about oil and I wouldn’t chase crude here. I’d wait for the broad-based market sell-off (which we are in the middle of) to drag the price of crude and other oil-related stocks down before going in and buying.

If you miss the oil trade because prices don’t pull back, there are other options. Crude’s march to $150 and beyond will create value in some very good stocks. For the long term investor, look at Boeing. Demand continues to rise for their fuel-efficient 787 Dreamliner because airlines are trying to offset their rising costs. Don’t think you have to be in oil-related stocks to benefit from the rise in oil prices. There are other safer ways to play this trade.