Recall the Barrel Standard. First mentioned in a 1980 column, the Barrel Standard is a measure of wealth I introduced to track the exchange rate between the price of oil and the stock market. Then, as now, oil prices were establishing new highs and stock prices were sinking.

Perhaps a look at history will tell us something.

In 1970, oil was $3.18 a barrel. Think of it as "the good old days." It was three years before the OPEC embargo reminded us that we need oil from the Middle East to run our economy. The Standard & Poor's 500 Index was at 92.15. That means it would take 34.5 units of S&P 500 to buy 1000 barrels of oil.

By 1975 oil prices had more than doubled and stock prices had fallen. So it took 85 units of S&P 500 to buy 1000 barrels of oil. And by 1980, when investors were about to give up on stocks, oil was $21 a barrel while the S&P was 135.76. So it took 159 units of S&P 500 to buy 1000 barrels of oil. That, it turns out, was near the peak for oil and the bottom for stocks.

By December of 1998--- the last time I wrote about the Barrel Standard--- oil was down to $11.18 a barrel and the S&P 500 was up to 1149. As a consequence, you only needed 9.7 units of S&P 500 to buy 1000 barrels of oil. Oil was dirt-cheap. We had enjoyed nearly two decades in which you needed less and less stock to buy a barrel of oil. Viewed as an exchange rate, oil had fallen by 94 percent.

Today, with oil testing $42 a barrel and the S&P 500 Index lower than it was in 1998, the trend has clearly reversed. It now takes 38.7 units of S&P 500 to buy 1000 barrels of oil. (See table below)    

  

The Barrel Standard, Revisited
Year	Oil Price	S&P 500 Index	Units of S&P500/ 1000 barrels of oil
1970	$3.18	92.15	34.5
1975	7.67	90.19	85.0
1980	21.59	135.76	159.0
1985	24.09	211.28	114.0
1990	20.03	330.22	60.7
1995	14.62	615.93	23.7
Dec-98	11.18	1149.00	9.7
May-2004	42.00	1085.00	38.71
Source: James A. Gibbs, Bloomberg

  

One message here is very clear: when oil prices rise, stock prices tend to fall. When oil prices sink, stock prices tend to rise. The question at hand is whether $40 a barrel oil is a transitory peak or a new reality.

My personal view is that $40 oil is the new reality. The era of cheap oil is over. As outlined in both a column and in "The Coming Generational Storm (MIT Press, $27.95)," my money is where my mouth is--- I've invested in energy stocks as a substitute for dollar based investments. Here's why:

• Ugly Reality #1. We love unlimited energy but we don't want to do anything to get it. Our capacity to deliver and refine oil is inadequate. We either haven't invested enough or haven't been allowed to invest enough. The most visible current example is the state of Massachusetts. They don't want wind farms off Cape Cod. They don't want increased LNG (Liquified Natural Gas) capacity, either. But they still expect homes to be heated and lighted.
• Ugly Reality #2. The Middle East remains the largest pool of oil reserves in the world. That's bad news for western civilization. There are promising areas for exploration elsewhere, but it is unlikely that any new find will rival the fields in Saudi Arabia. Meanwhile, global demand continues to increase. The supply/demand balance is likely to be a source of instability for the foreseeable future.
• Ugly Reality #3. There are disturbing signs that Hubbert's Peak is arriving as predicted. Using the techniques of geologist M. King Hubbert--- who predicted in the 1950's that domestic oil production would peak in 1970--- others have predicted global production would peak in this decade. Today, with production declines in some important oil fields, the idea is attracting more attention.

On the web:

December 23, 2003: Summing Up My 2003 Investments

December 20, 1998: How Cheap Can Oil Get?

November 10, 1996: A Contrarian View of Oil