Jim: You said that oil will go to $100/barrel before it hits$25/barrel. I’m not so sure.

The reason I’m confident that the Dow Jones industrial average will top 10,000 before it hits 6,000 is that stocks are a leading indicator. They anticipate recoveries, typically turning upward 6-9 months before the economy as a whole. We are already one year into the recession, so I’m guessing we are getting close to the point where stocks will turn the corner. When you add in the fact that valuations and yields are the most attractive I’ve seen in my adult investing life, the outlook for equities is quite good.

Oil, on the other hand, reflects mostly immediate, near-term supply and demand. If the economy gets worse before it gets better, stocks might see the light at the end of the tunnel, but oil won’t. It can’t. Prices will keep falling as demand deteriorates in real time and the current supply glut gets worse.

Remember, oil is expensive to store. For the most part, it won’t just sit around waiting to be used if there is a lack of demand. (Some can be stored, but not that much). It must be sold and used at whatever the current clearing price is.

And we have yet to see the magnitude of supply cutbacks in the oil market that we’ve seen in aluminum, copper and other commodities. The world is continuing to pump out millions and millions of barrels per oil. 

Here are a few facts to consider:

1. Oil has averaged a nominal price above $50/barrel in just three years in the history of the world: 2005 ($50.04/barrel), 2006 ($58.30/barrel) and 2007 ($64.20/barrel).
2. On an inflation-adjusted basis, oil has averaged an annual price above $50/barrel for just 12 of the 62 years of the post-war era.
3. The average inflation-adjusted price of oil in the post-war era is $33.65/barrel.
4. Oil traded below $25/barrel as recently as 2002.

As the saying goes, “This time it’s different” are the four most-expensive words in investing. So why not $25/barrel oil?

The truth is, I was amazed during the recent oil price retreat how quick people were to say that $100/barrel was the “right” price for oil. $100/barrel is off-the-charts historically, and completely neglects both the supply and demand impacts thathigh oil prices have.

To put it another way, stock prices are now trading where they were in 1997. What’s to say oil shouldn’t be trading where it was in 2002?

The truth is, I have no idea where oil prices are headed. But I don’t think it’s a gimme that they’re going back to $100/barrel. In fact, if you gave me 2-1 odds, I’d bet they hit $25/barrel first.

PS: One more thought about oil. Even if you stronglydisagree with me and think crude oil is a screaming buy, please be careful before you buy a crude oil futures ETF like the US Oil Fund (NYSEArca: USO). Oil is in a violent contango right now. A fund like USO faces a 3% monthly headwind from contango right now, meaning oil prices must rise about 3% each month just to offset the losses from rolling contracts forward.  Until that situation is reversed, investing in crude oil futures could be challenging … even if I’m wrong about crude oil prices.

Last 5 posts by Matt Hougan

• Just Getting To Fixed Income? - January 5th, 2009
• Yes, Jim, Perspective Is Important - December 31st, 2008
• Cap Gains Unfair - December 29th, 2008
• A Simple Example - December 23rd, 2008
• Why Market-Timing Might Work In Commodities - December 23rd, 2008