A sweeter scenario for 2007

By Jim Jubak

The case for gloom is, I admit, plenty strong.

Consumer spending, the big source of growth for the U.S. economy in this economic cycle, continues to slow, with growth dropping to 2.6% in the second quarter from 4.8% in the first quarter of 2006.

The real-estate money machine that fueled that growth in consumer spending has run out of gas. New home sales are falling -- down 4.3% in July -- and housing prices have flat-lined in many parts of the country. The housing market could get even cooler in 2007. On average, housing prices will climb just 0.43% in 2007, according to a survey of 48 economists by the Wall Street Journal. Factor in inflation -- projected at 2.7% in 2007 -- and real housing prices would fall by more than 2% in 2007.

Unit labor costs are soaring, up a revised 9% in the first quarter and 4.9% in the second quarter. That's certainly enough to put the inflation fighters at the Federal Reserve on high alert. A few more data points like that and the Federal Reserve could decide to start hiking interest rates again after the November elections. That would take another bite out of economic growth and stock prices.

Odds rise for recession in 2007

No wonder the gloom is getting awfully deep these days. On Sept. 8, for example, economists at HSBC Holdings (HBC, news, msgs) warned that the United States could face a recession in 2007. The U.S. economy is likely to grow -– at best -- by just 1.9% next year, the economists said, down from their earlier forecast of 2.6% growth in 2007 and their projections of 3.5% growth in 2006.

These economists are only marginally more pessimistic than the group surveyed by the Wall Street Journal. On average, these 48 economists are calling for economic growth in the United States to drop to an average of 2.5% for the last two quarters of 2006 and the first two quarters of 2007. That would be a significant drop from the average growth of 3.5% over the past four quarters.

And they put the odds of a recession in 2007, on average, at about 26%. That's a big jump from last spring, when this survey put the odds of a recession in 2007 at just 15%.

Economists say oil prices will drop

But before you decide to jump under the next bandwagon and end it all, consider this part of the Wall Street Journal survey as well: These economists are also projecting oil at $63.91 a barrel -- way down from the $70 to $80 range that marked the top in 2006 -- in June 2007.

That's not a huge decline from the Sept. 8 close at $66.25, but a slide to $64 by June would mark a huge change from expectations that oil was set to climb without a pause straight to $100 a barrel and beyond. A shift in that expectation, even if the change in the actual price of a barrel of oil isn't all that much from current levels, would have huge effects for the stock market and the economy.

The last month has given investors a lot of evidence of how a modest pullback in oil prices can fuel a stock market rally. For example, on Sept. 8, the $1.07 drop in the price of a barrel of oil (for October delivery) to $66.25 was enough to reverse a two-day sell-off and push the Dow Jones Industrial Average ($INDU) up 31 points. And the decline in oil from $77 on Aug. 8 to recent levels was enough to propel the S&P 500 Stock Index ($INX) to a 3% gain for the month and to sustain the market's rally into the historically weak last two weeks of August. The S&P 500 ($INX) climbed 1% during that period.

Lower oil prices would have domino effect

Gross Domestic Product (GDP) numbers don't react that quickly to short-term changes in energy prices, but $64 a barrel oil in June 2007 would be enough to give the economy a big boost over the course of a year. Consumers would have more to spend -- or at least not less -- thanks to lower or steady prices at the pump. Lower fuel prices would take the pressure off profits at companies from airlines to truckers to railroads to retailers such as Wal-Mart Stores (WMT, news, msgs). The Federal Reserve would breathe a sigh of relief, too, if energy costs stopped pushing prices upward, and Ben Bernanke and company at the Fed would be more likely to keep their fingers off the rate-increase trigger.

Sweet scenario, no? Lower oil prices keep economic growth higher than expected, keep the Federal Reserve on the sidelines, and push up stock prices in 2007.

Of course, right now all we've got is a bunch of economists projecting lower oil prices for 2007. (Do you know the one about how many economists it takes to change a light bulb? No? I'll post it on my message board, Market Talk with Jim Jubak.)

Here's the hard evidence

Certainly, before I'd put any money behind a scenario like this, I'd like to see just a little bit of hard evidence. So here's why I think we're due for a pause in 2007 in the long-term run-up of global oil prices.

• Lower U.S. growth for the next few quarters and European economic growth that falls below expectations will lower demand for oil. In the developed economies, oil consumption isn't that sensitive to economic growth anymore -- oil demand grows only about one-third as fast as GDP, according to the investment researchers at Sanford Bernstein -- but with demand and supply in such tight balance currently, even a slight drop in oil consumption due to slower economic growth will make a difference.

• Substitution of coal for oil in power generation in China. In the short run, only oil could offer China a way to meet its huge surge in demand for electrical power in 2004-2005. That produced a huge surge in China's demand for oil, up 14% in 2004. (The winter of 2004 was colder than normal in the Northern Hemisphere, which added to the big jump in oil demand that year.) The country has abundant supplies of cheaper and environmentally dirtier coal, but China's transportation system simply wasn't capable in the short term of getting the coal to power plants. Since the worst days of the crisis, China has upgraded its transportation and utility systems and the country is using less oil and more coal to generate electricity. China's demand for oil isn't going fall; it just isn't going to climb as fast as it did in 2004 and 2005 and will most likely match its growth in GDP going forward.

• The continued European shift from gasoline to more efficient vehicles burning diesel fuels and the recent market shift in the United States toward slightly more fuel-efficient cars instead of SUVs and trucks will reduce global oil consumption marginally.

• A gradual increase in global oil production will be sufficient to gradually put a little breathing room between supply and demand. Part of the huge run-up in oil prices was due to the lack of any global spare-production capacity. Any increase in demand increased fears that some customers would have to go without. And those fears led customers to be willing to pay larger and larger premiums to assure themselves of supply. The lack of global spare-production capacity was a result of underinvestment in the oil industry in the 1990s. The higher prices of recent years have reversed that trend and oil companies increased their capital budgets. Many of the new projects are relatively small, high-cost efforts that are only viable with oil north of $40 a barrel. But they should be enough, estimates Sanford Bernstein, to restore spare capacity to something like a normal 3% to 4% of demand instead of the recent crisis levels of 1% to 2%.

 1 | 2 | next >