David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).

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October 23, 2009

The $80 oil price is starting to worry me a little. Translate it into gasoline and you get somewhere around $2.50 per gallon or a little higher, depending on where in the US you fill up your tank. Add to that a little cold weather and expanding crack spreads in refineries, and the price will edge toward $3.

History-derived economic models show that the US consumer starts to change behavior as the price of gas approaches $3, and then goes into a more pronounced state of shock when it ranges higher, in the $3 to $4 corridor. The reaction is to cut spending and retrench if the consumer thinks the price is going to stay at the new higher level for a while. When the consumer thinks the price will not stay higher, he keeps on spending and buying on credit.

BUT –

That history is derived, and has been modeled, from a time period when household balance sheets were relatively solid and when credit was flowing easily and when the unemployment rate was close to 5%, not 10%. So that is why I am starting to worry.

There are no solid models of rising gas prices that I can find which give good estimates of what happens to consumers when the unemployment rate is 10% instead of 5% and when many household balance sheets are wrecked, and when the credit mechanism is damaged.

SO –

The issue now is what gasoline price change it takes to impact consumer’s behavior. Does the price have to go as high as previously to hurt? Some retail experts I consulted say yes and that there will be no change in the relationship. Others disagree and say there is a new lower level, but they have insufficient experience to estimate what it is.

SO –

We asked some fellow economists if they thought the relationship was linear or something else. There was consistent disagreement. Five two-handed economists had ten opinions. Some said yes to linear and others said no. Most thought that the impact of a change in gas price is much more severe in the current environment. No one said it was milder.

SO –

If a rising gas price is going to crunch the consumer more than normally, the fragile economic recovery may be about to be derailed. Remember that every penny on the gasoline price acts as a $1-billion direct tax on the consumer. This rule-of-thumb estimate is used to guess at the normal effect. But if this time is not normal and if the effect is magnified and more severe, who knows what the new rule of thumb should be? We don’t.

AND –

We worry that this issue is not being discussed by the policy makers, who are still wringing their hands over inflation fear. And we see an energy policy coming from the Obama administration that will only serve to raise the price of gasoline and tax the extraction industries. That explains why the drill rig count is down even as the oil price is going up.

Energy and oil may be the next “sleeper” to awaken and jolt markets. However, we think it is more likely to slow down the fragile recovery. When it does, oil and gasoline demand will shrink, not grow. That will put downward pressure on the oil price, even if the dollar is weak. This will be even more pronounced if the dollar rallies

Oil is now $80. We may just see $60 sooner than we see $100. I will take the “under” on this trade as long as there is no outbreak of war in the Middle East, no rumbling from Russia, and I will hope there is no tax policy in the US that hits the energy consumer in the middle of a recession that features a 10% unemployment rate. We already have a no-exploration policy in all but four of these United States.

The first two risks are geopolitical. The last one is just political, no “geo” needed. As my friend Loren Scott likes to say in his speeches, “All the oil in America is in four states: Texas, Louisiana, Mississippi and Alabama, and the dipsticks are in Washington.”

David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com

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