The recent plunge in oil prices has brought both optimism and pessimism to the economic landscape. Anyone who lives in Houston, as I do, knows that the price of oil is an important driver of the economic landscape. The plunge in oil prices in the 1980's is a solemn memory for many Houstonians, particularly for those in the oil patch that lived through it.

The problem with falling oil prices, economically speaking, is that oil and gas production make up a hefty chunk of the "mining and manufacturing" component of the employment rolls. Since 2000, when the oil price boom gained traction, Texas has comprised more than 40% of all jobs in the country according to first quarter data from the Dallas Federal Reserve.

Higher oil prices have led to more employment as energy companies explored and developed more aggressively. This has particularly been the case since the financial crisis as cheap financing has lead to an exploration "boom" in "shale fields."  However, as I discussed recently, there is a dark side to that "miracle".

"First, the development of the “shale oil” production over the last five years has caused oil inventories to surge at a time when demand for petroleum products is on the decline as shown below."

The drop in demand is being driven, no pun intended, by a change in demographics, a rise in telecommuting, a structural shift in unemployment (large pool of working age individuals outside of the labor force) and increases fuel efficiency. These dynamics are likely not to change in the foreseeable future as economic growth rates globally continue to "muddle along."

The obvious ramification of the surge in supply as demand stagnates is a “supply glut”which leads to further declines in oil prices. As prices fall, energy related business cut production by “shutting in” wells, cutting capital expenditure plans (which makes up almost 1/4th of all capex expenditures in the S&P 500), freezes and/or reductions in employement, and declines in revenue and profitability. Of course, the "ripple effect" of those actions impacts all of the related and ancilliary businesses from piping to coatings, trucking and transportation, restaurants and retail.

Do Lower Gasoline Prices Lead To Higher Consumption

The optimistic argument is that lower oil prices lead to lower gasoline prices that gives consumers more money to spend. The argument seems to be entirely logical since we know that roughly 80% of households in America effectively live paycheck-to-paycheck meaning they will spend, rather than save, any extra disposable income.

This argument is easy to prove by just comparing the annual change in inflation-adjusted (real) disposable incomes (DPI) to real gasoline prices. As gasoline prices fall, DPI should rise and vice-versa. However, as shown in the chart below this has not been much of the case.

Most of the changes in DPI have come from tax law changes, increases in welfare dependency and changes to actual compensation. As an example, the spike in DPI at the end of 2012 was due to massive dividend and bonus payouts in advance of the"fiscal cliff" tax changes rather than the drop oil prices. Importantly, the annual rate of change in DPI has been on the decline since the 1998 peak.

The follow up argument for lower gasoline prices is higher levels of spending by consumers. Again, this is easy enough to analyze by looking at real gasoline prices compared to retail "control purchases." I am using "control purchases" as it removes retail gasoline sales, automobiles, and building materials from the retail sales number to focus more on what consumers are buying on a regular basis.

As with DPI, the argument suggests that falling gasoline prices should lead to a rise in the annual rate of change in retail sales. The vertical orange line shows peaks in gasoline prices which should correspond to a subsequent increase in retail sales.

However, "retail sales" is only about 40% of the Personal Consumption Expenditure (PCE) number that comprises roughly 2/3rds of the economic GDP calculation. Therefore, we can also analyze falling gasoline prices as it relates to total PCE. Again, falling gas prices should lead to increases in PCE.

While the argument that declines in energy and gasoline prices should lead to stronger consumption sounds logical, the data suggests that this is not actually the case. With consumers heavily leveraged already, any increases in disposable incomes from lower gasoline prices are likely negligible in terms of their monthly spending.

Furthermore, as I predicted back in August, the onset of another extremely cold winterwill likely detour any savings from lower gasoline prices into higher electricity and heating oil costs. 

The most critical impact of a sustained decline in energy prices, at a time when the US dollar is rising, is a deterioration in the economic foundation. Exports of goods and services, which comprise about 40% of S&P 500 profits, are already under pressure from a surging U.S. dollar. Combine that with a sustained decline in oil prices that leads to cutbacks in capex, employment and incomes and you have the potential for substantially weaker economic growth than currently estimated.

The risk to investors is that with financial markets already pushing extremes in terms of bullish sentiment, complacency and valuations, there is little room for disappointment.  As John Hussman recently penned:

"Importantly, rich valuations here cannot be 'justified' by appeals to current interest rates or profit margins unless that justification carries with it the assumption that both zero interest rate policy and cyclically-elevated profit margins will be sustained for decades, coupled with the assumption that economic growth will proceed at historically normal rates."

John is right. While interest rates can surely remain suppressed for decades, particularly when economies are caught in a "liquidity trap" like Japan, however, profit margins are extremely "mean reverting." The decline in oil prices is important to watch as energy has a broad reach across the economic spectrum and the financial markets.

Lance Roberts