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The Oil Factor
By Stephen Leeb, PhD. and Donna Leeb

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 The Oil Factor

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The Oil Factor
By Stephen Leeb, PhD. and Donna Leeb
ISBN: 0446694061
Genre: Business & Money

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Chapter Excerpt from: The Oil Factor , by Stephen Leeb, PhD. and Donna Leeb

Chapter 1

Thirty Years of Oil

The most important events in history, the ones that will have the greatest impact on our lives for years to come, often slip by unnoticed at the time. Go to a library and scan issues of the New York Times from the fall of 1960. What was making news in that presidential election year, apart from coverage of the Kennedys' glamour and Nixon's five-o'clock shadow? Two tiny islands called Quemoy and Matsu; and Nikita Khrushchev; and our fledgling space program.

Definitely not grabbing headlines, in an era when oil was priced at under $2 a barrel and the U.S. satisfied around 70 percent of its oil needs through domestic production, was the decision, in September 1960, by five countries-Iran, Iraq, Saudi Arabia, Kuwait, and Venezuela-to form a loose coalition called the Organization of Petroleum Exporting States, or OPEC. But the ultimate repercussions of that event have been massive. In fact, as we will detail below, it is no exaggeration to say that OPEC, which gradually expanded to include Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, and Ecuador, has become the single most important determinant of the health, or lack thereof, of both our economy and our financial markets.

Ten years later, another oil-related economic milestone also got little attention. In 1970, U.S. domestic oil production, which up until then had been consistently rising, embarked on a decline, one that has continued ever since. To the extent that anyone noticed it at all, it was viewed as either a temporary anomaly or as simply no big ?.deal. Like the formation of OPEC, however, the decline in domestic oil production has been of critical importance to the economy and to investors.

Oil is key to all we do, to every facet of our economy. Or to put it more precisely, energy is key, and for now, because of a long-term failure spanning administrations of both parties to develop alternative energies, energy means oil. Our need for oil, our growing appetite for this critical resource, is the prism through which it is essential to view all that is happening in the world today and all that will occur tomorrow. This is true for all of us, citizens in general. And it is true in an even more specific way for investors who want to understand what is likely to happen in the financial markets in coming years and what they need to do to protect themselves and profit.

Above all, it's essential for investors to grasp, intellectually and viscerally, the following realities:

• For the last thirty years, the price of oil has been the single most important determinant of the economy and the stock market. Sharp rises in oil prices have been deadly for the economy and the stock market, while steady or declining prices, or even prices that increase only gradually, have led to good times. For investors, it's what we dub your "desert island, one phone call" indicator. If you can know only one thing about the world, make it the direction of oil prices over the preceding year, and you'll do better in the stock market than almost anyone else following any other indicator, from interest rates to corporate profits. This has been true for the last three decades, and it will remain true throughout the early part of this century-until we kick our oil habit and develop and switch to viable energy alternatives.

• Oil prices are a determinant over which, for the past thirty years, we have more or less ceded control. In other words, through good times and bad, we have exercised little real control over our own economic fate.

• Finally, the situation is about to shift from bad but acceptable to worse, because, as we'll detail in chapter 3, for all practical purposes the world is running out of economically extractable oil. This puts us more than ever at the mercy of the very few nations with significant untapped reserves-Saudi Arabia and to a lesser extent Iraq, Iran, and Kuwait. Over the long term it's clear that the only viable solution is to free ourselves from our dependence on oil entirely, by shifting to other forms of energy. But in the meantime, we are trapped in a tricky and dangerous present, in which we need to ensure that we have the oil we need to keep the economy going while we seek to develop alternatives on a meaningful scale. This doesn't mean that the economy is doomed or that there aren't significant profits to be made in the stock market during the tumultuous transition that lies ahead. It does mean, though, that you have to know what to look for-in particular, that you need to watch oil, tracking the direction of oil prices at any given time and then tailoring your investments to fit what oil dictates.

Below and in following chapters we'll discuss these three key points in detail. We'll explain where to go to find oil prices at any given time, how oil ties in with other salient economic realities, such as super-high levels of consumer debt, and what this means for the short-term and long-term outlook for the economy and stocks. In particular, we explain why the upshot is likely to be high and rising inflation accompanied by the ever-present risk of deflation, a volatile combination that will transform the investment environment. And we'll tell you exactly how to use trends in oil prices to catch each investment wave and to profit whether stocks are going up or down. In this chapter, though, we'll look at the recent past-at the decisive though often surprisingly overlooked hold oil has exerted over our lives for the past thirty years.

A Brief History of Oil Prices

It is striking, if you look back at the past thirty years, how closely changes in oil prices have mirrored both the economy and the stock market. During this period, rising oil prices have always preceded economic downturns and falling stocks. Falling oil prices have always led to economic upturns and rising stocks. It's that simple, that predictable.

And there is good reason for this strong correlation. For a long time, oil has been our major energy source, and economic growth depends on the availability of energy as much as the growth of a child depends on the availability of food. When energy is available at low prices, the outlook for growth is good, and stocks go up. When energy prices go up, growth becomes harder to achieve, and stocks go down. Now, you might point out that our economy has run on oil for longer than the past thirty years, and that's true. But in those earlier years, no one ever thought much about oil prices. Oil was just there, like air and water-other commodities we gave a lot less thought to back then. It was cheap, it was plentiful, and it was dependable. Businesses could count on getting all they needed, and so could consumers.

In the fall of 1973, that age of innocence vanished forever, as a result of the 35th OPEC conference, which began in Vienna in September and ended in October. This event transformed our economic landscape and forever changed how we think about oil. During that conference OPEC imposed restrictions on oil exports. In so doing, it engineered a 70 percent increase in oil prices, which rose to the then unheard-of level of more than $5 a barrel. In December the cartel met again, this time in Tehran, and took even more drastic action. Protesting U.S. support for Israel in the 1973 Yom Kippur War, it temporarily embargoed oil exports altogether. By early 1974 oil prices had jumped to more than $7 a barrel, more than 130 percent above levels that had prevailed just a few months earlier, in mid-1973, and, indeed, for the entire preceding decade.

OPEC had done what the Soviet Union, throughout the Cold War, had failed to do-demonstrated not by threats but by action our vulnerability to forces over which we had no control. The cartel continued to flex its muscles, and oil prices continued to rise throughout the 1970s, in a steady but constrained uptrend. Then the situation abruptly worsened. Propelled by the overthrow of the shah of Iran and the Iran-Iraq War, oil prices soared. By the end of 1979, oil-which had averaged a shade over $10 a barrel in 1978-was more than $18 a barrel. And by early 1981, prices had reached nearly $40 a barrel.

Then the pendulum shifted again. The reason: the West had reacted to the rise in prices by cutting back on its oil use through a combination of conservation and the development of other energy sources. Heavy investments in nuclear power and the development of coal and of oil fields outside of OPEC's reach began to pay dividends. The combination of lower demand and increased supply drastically reduced OPEC's ability to control prices. As a result, oil prices were in nearly free fall during much of the 1980s. From their highs of nearly $40 a barrel early in the decade, they plunged to a low of near $10 a barrel in 1986.

By mid-1987, though, oil prices rose significantly once more, though getting nowhere near their previous highs. The reason for the rise was, once again, OPEC, which, alarmed by prices in the single digits in 1986, had reined in production slightly. For the next three years oil prices fluctuated between the mid- and high teens without any obvious trend.

You probably remember what happened next. On August 2, 1990, Iraqi president Saddam Hussein ordered his army to take over Iraq's nearly defenseless neighbor, Kuwait, a Muslim country whose population numbered only about two million. Though Kuwait was barely a speck on the map and shared virtually no Western values, it took just twenty-four hours or so for the UN Security Council to order Iraq to withdraw. Why such a fuss over Kuwait? Oil, and a lot of it. Kuwait, a founding member of OPEC, was one of the world's largest oil producers. It was clear that Saddam had only one thing in mind, and that was possession of Kuwaiti oil. The threat of so much oil in the hands of an unpredictable dictator was enough to make the West act, and act decisively.

As the Gulf crisis unfolded, the oil markets responded by driving up the price of oil by over 50 percent in just a few weeks. A number of catastrophic scenarios were being bandied about. The most alarming one was damage to Saudi Arabia's oil fields. Many analysts argued that a desperate Saddam would send missiles to every corner of the Middle East, inflicting untold economic damage in the West. Saudi Arabia was considered the most likely target because it was the world's largest producer of oil. Oil prices soared to above $30 a barrel.

Once the shooting started, however, in mid-January 1991, it became clear that Saddam offered no real resistance and lacked the means to damage the Saudi fields. Though the Kuwaiti fields were left aflame, the Saudis had more than enough capacity to make up for the shortfall until the Kuwaiti fields were repaired. As a result, by early 1991 oil prices had fallen back to the high teens. For most of the rest of the decade, prices remained well under control. Oil hovered near $20, with the average price a shade above $19. Moreover, as figure 1a, "Oil in the 1990s," shows, whenever oil peeked above $20, it quickly backed down. Remember, too, that $20 oil in the 1990s was comparable, after adjusting for inflation, to $15 oil in the 1980s. It wasn't until the end of the decade that oil began to display any volatility at all. In 1998 OPEC, because of an internal battle over market share, turned on the taps full blast. The extra oil hit the markets just as the Asian economies were entering a serious swoon. At their lows in 1998 oil prices dropped to $10 a barrel. OPEC became more disciplined in 1999, and oil prices recovered all the way back to the mid-20s on the heels of surging economic growth. Oil finished the decade at about $25 a barrel, not alarming but still the highest level since the Persian Gulf War of 1990-91.

Oil, the Economy, and the Stock Market

During the years between 1973 and the turn of the century, while oil prices bounced up and down between a low of around $10 a barrel and a high of near $40, we experienced five recessions and several periods of strong economic growth. Meanwhile, as far as stocks went, we've had bear markets, in which stocks dropped nearly 50 percent, and some prolonged and glorious bull markets. Who says life is dull?

The point is that if you looked at when the economy went into a tailspin and when stocks tanked, you'd see that these periods were always preceded by rising oil prices. By the same token, falling oil prices preceded economic good times and strong financial markets. It's like those acetate overlays in books depicting the human body, in which a sheet depicting branching blood vessels lies neatly over a sheet showing the skeletal frame. If we had such overlays, we could fit economic and market trends snugly within changes in oil prices.

Let's briefly look back at the economy and market during those same thirty years since 1973 and see just how their ups and downs intersected with trends in oil. It is no coincidence that the period 1973-82-which saw oil prices rise from below $5 a barrel to nearly $40 a barrel-was one of the most turbulent in U.S. economic history. Inflation soared into double digits, and the economy experienced three recessions. Moreover, during those years, economic dogma was rewritten. Until then there was a well-established relationship between economic growth and inflation. When growth was strong, inflation would pick up; when growth was reined in-by rises in interest rates and a tighter money supply-inflation would fall.

This relationship, which had long been a reliable road map for economic policy, was blasted out of the water by events in the 1970s. Because of our lack of control over oil, inflation and recession were no longer mutually exclusive. As OPEC engineered rises in oil prices, prices rose across the board, even in the face of a slowing economy.

In the 1970s, a new term entered the economic lexicon: "stagflation," a combination of stagnant growth and high inflation. At times we didn't know which of these enemies to fight first. In 1974, thanks in part to Alan Greenspan, then economic adviser to President Ford, Americans were urged to wear "WIN" buttons, standing for "whip inflation now." Those buttons were quickly discarded when it turned out that a more devastating enemy was the recession that had started in 1973 with no one noticing.

Well, not exactly nobody-the stock market clearly noticed. The year 1974 was one of the worst ever for stocks. Between the start of the oil embargo in December 1973 and their low in 1974, big-cap stocks as measured by the S&P 500 plunged by over 30 percent, while smaller-cap stocks suffered even more damage. With the exception of gold stocks, nothing was spared.

For the remainder of the 1970s, with oil uptrended but not abruptly so, and inflation seemingly on a permanently higher plateau, stocks treaded water. But then the dramatic rises in oil prices at the end of the decade and early in the 1980s-the result of political turmoil in the Middle East-hit the economy and the stock market hard. Between 1980 and 1982, the economy suffered through two recessions as unemployment soared into double digits. Stocks bobbed and weaved and in the end generated negative real returns for the period.

Then, however-as oil prices subsided and then dropped sharply throughout the 1980s, from their high of near $40 a barrel to a low of around $10 a barrel in 1986-a striking turnaround occurred. In the summer of 1982 a great bull market began. The Dow rose from a low of 780 in August of that year to a high of 2700 in 1987, and bonds soared as well. It was one of the strongest and longest bull markets ever. The economy was in high gear as well: economic growth was steady and strong, while inflation was decisively tamed, falling from the mid-teens at the start of the period to just a trace above 1 percent for the broad-based consumer price index (CPI) by the end of 1986. In short, it was an economically ideal period that was the mirror image of the 1970s. And it was made possible by well-behaved oil prices.

This period of nearly unmatched prosperity basically brought about the end of the Cold War, by giving us the ability to build up our defense establishment to the point where the Soviets simply could no longer compete. The triumph of capitalism was, seemingly, a great victory for the U.S. and the West, and not surprisingly it dominated the headlines and op-ed columns of the time. But it's clear in retrospect that everyone failed to appreciate the underlying dynamics that made our triumph possible. Oil was the silent dignitary at the table, the one that secretly held all the cards. The correlation between oil and economic prosperity was powerful and it was there for all to see, but no one was paying attention. The issue that is coming to a head now-that will determine our fate and possibly even our survival in the twenty-first century-was nowhere on our radar screens at a time when we more easily could have done something about it.

In 1987, we briefly experienced the flip side of the oil/prosperity correlation. As oil prices began to rise again, into the mid-teens-low by the standards set in the 1970s but high compared to the benign levels of the 1980s-other commodities rose as well. Inflation climbed back to above 4 percent, and the dollar began to tumble. Predictably, stocks, which had been soaring for five years, began to falter during the summer of 1987 as well. The wavering culminated in one of the worst market sell-offs in history. On Black Monday, the Dow Jones Industrial Average plunged more than 500 points, and for the month stocks fell by more than 30 percent.

Staggering as the crash was, it actually marked the only time since 1973 that a sharp rise in oil did not end up triggering economic recession. The reason: because inflation was at still-manageable levels, the Fed had the leeway to pump sufficient money into the economy to ward off a downturn. The drop in 1987 turned out to be just a temporary dip on the road to even greater prosperity and much higher stock prices. For the three years following the 1987 crash, with oil prices essentially a nonevent, the market was in high gear. By their highs in 1990, stocks not only had recovered the ground lost in the 1987 crash but were more than 20 percent above their 1987 highs.

All was right with oil, all was right with the world, and investors were making money hand over fist.

This euphoric period lasted until Saddam's invasion of Kuwait sent oil prices spiraling up by over 50 percent in just a few weeks, to more than $30 a barrel. The economy began its first recession in almost a decade, and stocks were pummeled.

As noted above, though, it quickly became clear that Saddam lacked the ability to cripple oil production. And as oil prices collapsed back to the high teens, the recession ended. Stocks once again embarked upon a bull run-and this one was to be a bull run for the ages.

Between 1991 and 2000, with oil prices remaining well under control, stocks staged one of the greatest rallies any financial market has ever seen. If you had invested in the S&P 500, say, by buying the Vanguard 500 Index Fund, in January 1991, you would have gained on average 20 percent a year for the next nine years. To put it differently, a $10,000 investment would have turned into more than $50,000. And because those nine years were ones of low inflation, your gains were mostly real gains in terms of their actual purchasing power. Moreover, as everyone knows, while the market as a whole was thriving, the tech sector, especially as the decade drew to a close, was on a real tear. All in all, these were unforgettable years, in which growth seemed to be on an ever-rising trajectory while inflation remained a virtual no-show.

Not the Same Old Oil Story

You may have noticed that in detailing the history of oil prices, the economy, and the stock market, we began our narrative in 1973 and seem to have halted it somewhere around 1999. You might wonder if on some psychological level this represents wishful thinking, a desire to linger in that relatively trouble-free period forever. Maybe so, but there is more to it than that. For toward the end of 1999 we began to move on to a new paradigm involving oil, a qualitatively different situation that requires that we look at the years since then separately.

You'll recall that in the 1990s, oil prices were stable, until 1998 averaging just a touch below $20 a barrel and quickly coming down anytime they ventured above the $20 level. Then they fell, as OPEC miscalculated and raised output just as the Asian economies were tanking. Once OPEC got its act together, prices rose once more, supported by the surging economic growth of 1999.

And then something out of the ordinary happened. Oil kept rising. By the third quarter of 2000, even though worldwide economic growth had begun to slow and the stock market was retreating, oil climbed above $35 a barrel, more than three times the lows of late 1998.

With the advent of winter and the threat of cripplingly high home heating oil prices, oil entered our consciousness, becoming a front-and-center crisis for a while. President Clinton authorized the release of oil from the Strategic Petroleum Reserve (SPR), the first time this emergency reserve had been used in peacetime. The only time prior to 2000 that oil had been released from the reserve was during the 1990-91 Gulf War. Clearly, the decision to use the SPR to curb soaring energy prices in the winter of 2000, whatever its political motivations, was an acknowledgment of the fact that oil prices were so high as to constitute at least a mini-crisis.

Why didn't oil prices come down in the early 2000s, when, as the result of slower worldwide economic growth, demand for oil was, if not lessening, growing at a very sluggish pace? Economic growth during those years was just 2.5 percent, about 20 percent slower than the average rate of growth during the preceding fifty years.

In fact, other than the recessions of the early 1980s and the 1990-91 period, it was the slowest-growing four-year period in postwar history. During those earlier recessions, oil prices dropped sharply. Indeed, until 1999, oil prices always fell during periods of economic weakness, rising only when demand was rising or as a result of ephemeral political disturbances. In other words, for most of the postwar period, oil prices were demand-driven.

But in 1999-2002, even though demand was weak, prices remained at historically high levels. This was due to a momentous transformation that had occurred in the dynamics of the oil industry:

oil prices had become supply-driven. And the reason that had happened was that for the first time since its formation, OPEC was no longer just another player, albeit an important one, in the oil arena. It had become the controlling player.

Between 1982 and 1998, the oil-producing world outside of OPEC had been able to increase oil production enough to accommodate economic growth. In 1999, however, Britain and other non-OPEC oil producers hit the point where any increases in production were minimal. The only area outside of OPEC capable of meaningful increases in production was the former Soviet Union (FSU). And increases by the FSU were little more than sufficient to satisfy the world's marginal increase in demand.

To put it differently, by 1999 the world was using all the oil that producers outside of OPEC not only were generating but that they were capable of generating. Supply was barely keeping up with demand. The upshot: as the world steps up its need for oil-and as we'll explain, it is a given that it will, unless we enter a protracted worldwide recession-the only countries that can supply the extra barrels are OPEC nations.

The result is that since 1999, OPEC, through relatively small changes in its production quotas, has been able to exercise almost complete control over oil prices. Oil demand in the world has over-taken the ability of all but a small group of nations to supply the oil that is essential for world economies to survive.

One key question is whether this is a temporary imbalance or a new and more permanent reality. As we'll discuss in chapter 3, all the evidence points to it being the latter. Nothing the West can do- other than end its reliance on oil altogether by developing alternatives on a large scale-will free it of its dependence on Middle Eastern oil. And nothing other than the development of alternative energies (or permanent recession/depression, an unacceptable outcome) will forestall oil soaring to ever higher levels, though possibly with temporary periods of retrenchment. The tragedy is that because we have waited so long, nothing but soaring oil prices will push us to develop those oil alternatives on a grand enough scale.

So there you have it-an overview of the fateful dance between oil, the economy, and stocks. Next chapter we look in more detail at the relationship between oil and the stock market and give you precise rules for using oil prices to get in and out of stocks.

Key Points:

Oil is essential to all we do.

Since 1973, the economy and stock market have danced to oil's tune. Sharp rises in oil prices have led to recession/stagflation and plummeting stocks, while declining prices or prices that are just mildly uptrended have led to good times.

For most of the 1990s, whenever oil prices rose above $20 a barrel, they came down. But starting in 1999, prices remained uptrended as the world reached the point where it was consuming all the oil that non-OPEC producers could provide.

Rising oil prices will likely lead to an inflationary economy punctuated by occasional deflationary scares.

Excerpted from The Oil Factor , by Stephen Leeb, PhD. and Donna Leeb . Copyright (c) 2004 by Stephen Leeb and Donna Leeb. Reprinted by permission of Little, Brown and Company, New York, NY. All rights reserved.

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