Historically many factors contributed to making our country big and strong economically.  Cheap oil has played a significant role in shaping the United States .  In fact as recently as 1998 a barrel of oil was cheaper than a barrel of clean water (see Biz-Journal article).

If you look at the design of cities and suburbs in America you can't help notice the long distances between our homes and our work places or the local grocery store.  This was done so on purpose starting soon after World War II.  Oil was cheap and before we knew it nearly every kind of machine known to man used petrol, diesel, kerosene etc. all by-products of oil.  To top it off, no one had the foresight to build good reliable public transportation, so that one could actually survive without owning a car.  In most countries around the world a car is a luxury not a necessity, unlike here.

We also built a network of roads and highways to facilitate the transportation of goods around the country.  This again was done mostly after World War II.  All these decisions one by one ended up making us slaves to cars and trucks.  Both of which need oil to run.

Peak Oil Theory

Many of you have heard of the Peak Oil Theory which states that the world oil production will peak out soon.  People may argue about the exact year, but the general consensus is around 2007.  The United State ’s reserves peaked out in the seventies, and today we import far more than we produce.  What does this oil peaking out mean?  What it means is that each barrel of oil coming out of the ground will be more expensive than the previous barrel of oil.  It does not mean the flow of oil is ending.  In fact there is enough oil for another 7 or 8 decades if not more.  However, the price of oil is going to be in a steady climb as long as we consume it at the current rate.

Prices and Consumption

In 1998 the world consumption of oil was around 72 million barrels a day; the 2005 forecast is 83-84 - and all that in 7 odd years.  Just 2 years ago in August 2003 oil was trading at $32.00 a barrel.  Just last week it looked like it was going to touch $70 a barrel.  Today people are paying close to $3.00 a gallon at the pumps.  I think we are going to be paying far more as time goes by.  A lot of the increase in consumption is now coming from growing economies mainly China and India.  The size of their population puts a lot of demand on energy in general.

We use it to warm our houses, drive cars, produce electricity and a lot of other things.  All our groceries are trucked around the country.  Sooner rather than later the high price of oil is going to seep into the economy and start to push inflation up.  In my opinion the feds will have no choice but to do whatever it needs to keep it in check - read higher interest rates.

Inflation and Debt

The high price of oil is going to make the price of producing goods and services more expensive.  Guess who will assume the burden of that increase? Us!  Manufacturers and retailers will have no choice but to pass along these increased costs to the consumers.  We will have to start paying higher prices for all the things we consume.

When it becomes expensive to borrow money, firms usually cut back on growth.  With pressure on prices these very firms will have to increase the price of their goods and services.  As prices go up, demand will start to fall and to stay profitable those firms will start cutting staff.  I won't be surprised to see higher inflation and unemployment in years to come.

To make matters worse we have a national trade deficit that seems to be growing to the size of this planet.  We are so dependent upon foreign countries buying our debt every week at bond auctions that we would have a heart attack if they all decided not to come and buy our debt.  To make our debt attractive to them we have to provide a decent return on investment in the form of high interest rates.  The US government debt has no credit rating in that it is considered 100% safe.  We have never defaulted on our interest and principle payments.  We just borrow more to pay last month’s payment.

Another thing that is going to effect inflation is China 's decision to start letting their currency, the Yuan, float or unpeg it from the value of the US dollar.  Now Wal-Mart and other retailers will have to pay more to get goods produced there.  Remember the cost of shipping those products is also going to go up (with the cost of oil).  Again we will pay for these increases.  I mention all this since it all plays a role in what I think is going to happen some time after 2007.

How Will This Affect Real Estate

When we get to $5.00 a gallon at the pumps, we are going to start feeling the pain.  Because by then that lovely salad being trucked from California to the east coast is going to cost a lot more than today.  Yes I said $5.00 at the pumps.  I think at the current rate of consumption we will get there fast.

What happens when things get expensive and people start getting laid off at work?  They will then tighten their belts.  Nobody is going to be buying expensive cars and multi-million dollar homes.  Real Estate will suffer sooner or later.  There will always be counties within each state that are not going to be as affected as others, but I see a lot of hot air being released from the real estate market.  So if you were planning to buy that multi-million dollar home, maybe you should think about it again.  You might get a great deal in about 3-5 years.

What Should We Do?

Here is how I think this outlook should impact long term investments.  What I mean by long term investments is money that you will not touch before you retire, like your 401K, IRA and SEPP.  Not the money you use to day trade.  Start putting a fair chunk of your holdings in anything to do with energy.  That includes oil, oil shipping companies and other oil transport stocks, utility companies that may build new nuclear energy plants in the coming years as an alternative to oil.  Some of the stocks that come to my mind are Exxon Mobil, Chevron, and Valero etc.

Do not buy and sell these positions, just buy and hold on tight.  The time to sell them will be when you start reading about real practical alternatives to oil.  Not some hype being experimented in a laboratory.  Because in the real world we still need to manufacture clothes, grow and ship food every single day.  Many of the energy alternatives that I have read about still need oil in some form to run.

Conclusion

You may consider my outlook a picture of doom and gloom but until something drastically changes in the world where we are not so dependent upon oil I would say we are in for a rough economic ride in the near future.