Analysis: Another Look at The Bird

by  Trey Cowan

In a January 5, 2011 article, we dubbed the Dow Jones Transportation Index (DJT) the canary in the coal mine based on its predictive properties relative to oil price declines. Par for the course, the recent decline in WTI crude prices was in fact preceded by a pullback in the DJT last week. Specifically, the DJT fell 3% for the week ending April 8th. Crude futures were advancing last week (improving 4%). With the last two daily declines, oil prices are now 6% below their recent peak closing price of $112.73, set last Friday on April 8th. Given their lagging tendency, relative to the Dow Jones Transportation Index, we would expect this recent correction in oil prices to find its bottom soon.

Why this pattern occurs is really no mystery. The transportation markets are a leading indicator of the market's perception on economic activity. Higher fuel prices at some point curtail activity levels across the board, effectively diminishing demand for not just fuel but all goods and services. Should we see a dramatic pullback in the transportation index beyond the recent low set in March, barring other factors extant to macroeconomic conditions, then we would expect oil to retrace back to levels of $90 per barrel seen at onset of the year.

We are already starting to see signs that higher gasoline prices are causing a shift in consumer behavior. At the pump, gas station owners have begun to report that the frequency of customers and volume of gasoline purchases is dropping on a weekly basis. The numbers support these claims as the MasterCard Spending Pulse, which tracks sales at 140,000 gas stations, reports gasoline consumption has been falling for the past 6 weeks straight.

Back in January we warned of this phenomenon regarding demand destruction in our article "Panning Out". Here is what we said:

There is a real threshold that causes consumers to modify their driving patterns (i.e. a shrinking discretionary budget giving way to a reduction in miles driven) that could stall the current economic recovery underway.

Assuming that the average amount of annual discretionary spent per US household is approximately $1,000, then a $0.75 per gallon increase in gas prices would absorb practically all the discretionary budget for a two-car family. Using average 2010 gasoline prices as the base, this would imply that US drivers will see their discretionary budgets evaporate once gasoline prices top $3.50 per gallon.

As demonstrated in the following chart, you can see that what is occurring today corresponds with our January prediction.

Sustained energy demand destruction, in our opinion, would likely spread to other areas of the economy. So, while government officials look to higher energy prices as a means to spur innovation in alternative energy sources, the trade-off could be a derailment of the current economic recovery. While we do not have a calamity or supply disruption that at other times would merit tapping the Strategic Petroleum Reserve, a whole-hearted dismissal of utilizing this tool puts the United States' energy policy in a game of chicken with our economic recovery.