Independent Investor: Oil — The New Tax Cut

On Thursday, for only the third time in its history, the International Energy Agency decided to release 60 million barrels of oil from global strategic petroleum reserves. They did so in order to "ensure a soft landing for the world economy."

As readers are aware, I suggested that investors "take profits" on oil as it soared past $100 a barrel almost two months ago. I argued that the clearing price on oil should be closer to $85 a barrel, given the slow growth of world economies. I was early in my recommendation, since oil subsequently climbed as high as $112 a barrel before plummeting to its present level of around $90 a barrel. I fully expect my price target will be reached in the coming weeks.

However, while oil dropped 5 percent Thursday, generating an annualized benefit of $36 billion to American consumers, the stock market fell by over a percent equating to a $200 billion loss. To me, that is a major contradiction. Here's why.

In energy, the rule of thumb economists often site is for every $10 increase in the price of oil, Gross Domestic Product (GDP) drops by one half of one percent. By March of this year, we had experienced a $25 hike in a barrel of oil in a very short time period. Economists were predicting that when (not if) oil reached $120 a barrel, the U.S. economy could easily fall back into recession.

Consumers bear the brunt of higher energy prices. Every one cent increase in the price of gasoline takes $1 billion out of our pockets. And actually it is much more than that (almost double) when you include things like home heating, electricity and price rises in alternative sources of fuel such as propane.

The real tipping point in impacting our consumption behavior occurs when energy prices reach 6 percent of average consumer spending, which occurred in March 2011 at 6.27 percent of spending. At that point, the top 20 percent of income earning Americans were spending 7.9 percent of their disposable income on food and energy. That may be a manageable hit for the rich, but not so for the bottom 20 percent of income-generating Americans. For them, energy and food account for a whopping 44.1 percent of after tax income. No wonder consumer spending and employment fell off a cliff.

As a result of higher energy and food prices, together with the fallout from the Japanese earthquake and tsunami, our economy has hit a soft patch which triggered the present decline in the stock markets. But circumstances have changed and in my opinion it won't be long before market players begin to realize that.

We can't have it both ways. The steep decline in oil and other commodity prices will boost consumer spending and economic growth while reducing unemployment. For consumers, it should be a matter of days before we begin to see this decline reflected in the price at the pump, in electric bills and in other areas. It is an instant and fairly hefty equivalent to a tax cut. Corporations will feel it too, but consumers benefit from that as well in the form of lower prices for products.

Right now, investors can't see the forest for the trees. With Greece threatening to collapse, unemployment rising a bit and the economy still slowing, it is hard to focus on what is just around the corner. But that, my dear reader, is exactly why I write this column — to help you focus on the horizon because there are better days are ahead.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.