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Oil Prices: Cause or Effect?

Written by Geoffrey Pike
Posted September 4, 2015

Canada is officially in a recession.

The economy contracted in the second quarter by 0.8% after going down by 0.5% in the first quarter. So if you define a recession as two consecutive quarters of negative growth, then Canadians have a recession on their hands.

Not that Canadian politics matter much to the rest of the world, but it should make for some interesting elections in October in Canada, where Prime Minister Stephen Harper is looking to maintain his position.

As with anywhere, the prime minister probably doesn’t have that much of an impact on the economy. It tends to be the central bank and the various government bureaucracies that have the greatest effect. Still, we know prime ministers and presidents typically get much of the blame for a bad economy.

Unsurprisingly, Harper is blaming much of the economic ills on lower commodity prices. In particular, oil prices have fallen quite dramatically over the last year. Canada is the fifth-largest oil producer in the world, which is significant for a country of about 35 million people.

Many Americans don’t realize that Canada is the United States’ number one trading partner. Perhaps many Canadians don’t realize this fact, either.

There are certainly some political differences between the U.S. and Canada, but Canada probably more closely resembles the U.S. than any other country, particularly in economic terms. There may be Americans and Canadians who don’t want to admit this, but there are more similarities than differences. The two countries tend to follow similar policies.

In that sense, Americans may want to pay attention to the recession happening in Canada. This is the number one trading partner of the U.S., and the economies are closely tied. The U.S. economy is obviously far bigger overall, but the vulnerabilities tend to be proportional.

There is no question that lower oil prices will affect profitability for the energy industry in Canada. Harper is insistent that the rest of the economy in Canada is doing fine, but of course he is going to say that.

While lower oil prices hurt certain sectors, it should be beneficial to consumers who will pay less to fill up their cars, among other things.

The Global Economy

For anyone paying attention to the financial news, it is obvious that China is in a major economic downturn. Stocks there have been plummeting, despite desperate attempts by the government to rig the markets. And let’s not forget about the real estate bubble in China that hasn’t hit the ground yet.

Demand for commodities in China is down. It isn’t just oil — it is also commodities such as copper, aluminum, iron ore, and coal. Gold is a bit less certain, but that is more of a financial investment than a commodity used for industrial purposes.

It is hard for China to blame its economic woes on falling commodity prices. If anything, it is the other way around. A weakening Chinese economy and less demand for energy and industrial metals used to produce goods is driving commodity prices down.

In the case of Canada, it is hard to blame a small country (in terms of population) for bringing down commodity prices. That is why the prime minister can make a case that commodity prices are bringing down the Canadian economy and not the other way around.

It is important to realize, though, that we really do live in a global economy now. The major countries of the world are tied closer together than at any other time in history. There is more trade than ever before, and financial markets are all connected with technology.

But there is an even bigger point to be made about today’s global economy. The major economic players of the world have followed similar policies. Unfortunately, these have mostly been Keynesian policies.

When you look at China, Japan, much of Western Europe, and even the United States, there has been a rather consistent policy of the last eight years (at least) of big monetary inflation, ever-increasing debt, and economic central planning.

The degree of debt and monetary inflation differs between places, but we can’t avoid the similar vulnerabilities between all places. You can also include Canada in this, even though it is relatively small.

Don’t Confuse Cause and Effect

Some Canadian officials are saying that lower energy prices are the cause of the Canadian recession. But confusing cause and effect is one of the biggest mistakes in economics.

Instead of lower oil prices being a cause of the recession, what if the lower oil prices were a result of an economic slowdown? Now, I realize that worldwide demand impacts oil prices, and Canada is a very small portion of that. But again, it seems that all of the major economic players are closely tied right now.

Maybe the lower oil prices were the canary in the coalmine for the global economy. Lower oil prices may not be causing economic slowdowns around the world any more than a wet sidewalk is causing it to rain.

Consider that the Chinese economy is hurting big time, and it is one of the biggest players. Japan, despite all of the easy money and low interest rates, is struggling economically and may also be entering a recession.

We know the major troubles in Western Europe with Greece. There are also major debt problems in Italy, Spain, Portugal, and elsewhere. Even the so-called economic powerhouse of Germany is not doing all that well.

The U.S. economy is going along with lower unemployment numbers, but even here there is a lot more uncertainty than just a month ago, with stocks now falling heavily.

If you look back to 2008, oil prices peaked out in July 2008. The U.S. was already in recession, but it was not officially known yet. It wasn't until a couple of months later that stocks began to plummet and we officially entered the financial crisis. Oil prices were already headed downward.

In 2008, the fall in oil did not precede the stock market collapse by more than a couple of months, but it was still ahead of it. We have to consider, though, that oil is a global commodity that is affected by global demand. It is probably not a coincidence that the fall in oil preceded the trouble in China coming to light.

In other words, lower oil prices are not causing economic downturns worldwide. If it were just Saudi Arabia in an economic downturn, that might be understood. But this doesn’t apply to China.

If anything, the economic contractions taking place worldwide are causing lower energy prices due to reduced demand. Economic conditions were already weak when oil started its decline, but we just didn’t know it yet.

Commodity Investing

So where does this leave commodity investors? If economic turmoil continues, then this will likely be bad news for commodity investors. Anything used for industrial purposes is going to suffer.

Of course, this doesn’t include gold, which is not used primarily as an industrial metal. Gold is still used as a hedge against currency depreciation and a hedge against disaster in general. It is still used for reserves by central banks. It was interesting that gold actually held up pretty well in the last few weeks in the face of falling U.S. stocks.

Even gold may fall, as it did in late 2008. But it is always something to have for insurance purposes, and it will likely hold up much better than other metals, including silver, that are used more for industrial purposes.

As far as oil goes, it could go down in price even more, but it will not likely be dramatic. It is actually a much safer investment now than it was a year ago when prices were high. But if you invest in oil, you may need to buy an exchange-traded fund. The energy companies are more vulnerable at this point, at least in the short term.

In the long run, barring some major unexpected technological breakthrough in energy, oil will likely do well. Even if there is a major global economic downturn, there will still be demand for energy, and it will pick up again in the future. If you are buying for the long run, you can’t go wrong with a small allocation of your portfolio going to oil.

Despite the failures of the central banks worldwide, if there is a major economic downturn, you can expect central banks to double down and create even more money out of thin air and for governments to increase debt loads even more.

Due to the depreciating currencies of all countries, this will ultimately be a reason to own commodities, especially silver and gold. When more people figure out that central banks can create unlimited amounts of money, then hard assets will once again be in high demand.

Until next time,

Geoffrey Pike for Wealth Daily

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