Economics and the mid-life crisis have much in common: Both dwell on foregone opportunities

C'est la vie; c'est la guerre; c'est la pomme de terre . . . . . . . . . . . . . email: jpalmer at uwo dot ca

. . . . . . . . . . .Richard Posner should be awarded the next Nobel Prize in Economics . . . . . . . . . . . .

Thursday, June 30, 2005

Buttonwood on Oil Prices

Those who subscribe to The Economist can receive a weekly e-mail called, "The Global Agenda." It usually concludes with an interesting column, called "Buttonwood," the most recent of which is about Oil Prices:

... The surprise is not that the price of oil is rising. It has been doing so, broadly speaking, for a year.

... The surprise is rather that it took share prices so long to fall in response. In the month from May 22nd, oil prices rose by 21% yet the S&P 500 went up by 2.1%—a respectable clip. When oil first touched $60 it knocked share prices back a bit for three days, but they resumed their climb thereafter. True, some of that gain is accounted for by oil companies and their suppliers, who are suddenly being touted as a buy all over town. But what about other sectors?

One theory is that both shares and oil have been rising in response to common factors: buoyant economic growth and profits, and low interest rates.
She continues, citing research showing

that oil-price changes and stockmarket returns are linked but lagged: if oil prices rise, shares do fall, but not right away. Shares of obviously energy-related firms adjust at once, but broad stockmarket returns fall only during the following month or even two months—a pattern that is clearest with biggish oil increases and in countries that are most dependent on energy. This, if true, suggests a genuine market inefficiency. [emphasis added]

On that model, expect shares to fall next month—or at least fail to make the gains they would otherwise have made.

... Oil bears, conversely, see demand for oil slowing as economic growth slows, especially in China (whose imports dropped slightly in the first five months of this year, says Andy Xie of Morgan Stanley). And alternative sources of oil—Canada’s tar sands, Africa’s deepwater reserves—are nearer than many think: Cambridge Energy Research Associates, a think-tank, predicts that these and other developments will provide some 6m-7.5m bpd more capacity than the world needs by the end of the decade.
If there really is a lagged adjustment of share prices to oil prices, it is time to go liquid if you expect oil prices to continue to rise. But if you expect oil prices to fall, maybe the equity market is due for another rise. So, according to this hypothesis, how you treat the equity market might also be a reflection of your oil price expectations.

But why does the inefficiency exist?
And if it does still exist, will it soon be arbitraged away?

Phil Miller also has some material about oil prices at Market Power.
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