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Oil prices jumped 40% this year—but don’t get too excited

A more than 40-percent jump in price in less than 12 months would constitute a spectacular year for any asset. That's exactly what oil did, rising from a low of $36 a barrel in January to about $52 a barrel in recent months.

Hedge-fund managers are stunned that their year could have been made so easily. Even in the days following the election, oil was still trading in the low $40s. It is up more than 15 percent in the past month alone.

But here's why that isn't cause for celebration just yet.

When oil was near $100 per barrel a few of years ago, U.S. production, aided by new technologies like hydraulic fracturing and horizontal drilling, drove a huge increase in the worldwide oil supply. Absent a corresponding increase in demand, the price of "black gold" plunged. In response to the crash in prices, the OPEC countries have now agreed to limit production. The reduction in production has caused the oil price to firm considerably, and we now sit at close to a 52-week high. It's an important time to remember Econ 101 because this price increase is not being driven by increasing demand. Increasing demand is a healthier economic sign.



Increasing demand for oil is a harbinger of better economic growth. Limiting supply, on the other hand, can have undesired economic consequences. In a tepid economy, like our current one, supply-driven price increases act as a tax and slow discretionary consumption. As gas prices rise for consumers, there is less money left over for discretionary spending and savings.

We will see if the OPEC agreement has legs this time. The key to any OPEC deal is how many of the members will actually abide by the deal. There is always some cheating. Some of the members will quietly sell more oil (provide more supply) than agreed upon in order to fatten their own coffers. Other members will flatly declare their intent to continue producing at previous levels.

Oil stocks are doing well on the news. Along with bank stocks, they have been among the best performers of the past 30 days. Oil producers and servicers have struggled to maintain profit margins as the price per barrel declined from $100 to $36. The current rebound above $50 offers a sigh of relief. But without organic economic growth, and with the likelihood that the OPEC agreement will be tenuous at best, one must ask how long higher prices can be maintained.

While the average price of gasoline has remained steady at $2.18 per gallon according to AAA, the price of natural gas has soared from $2.80 in early November to over $3.60. Heating oil is also climbing, and increases in diesel and jet fuel are underway. In time, these will be a drag not only on consumer wallets but corporate profits as well.

The increase in energy prices will serve as yet another developing headwind for the economy and markets. The near-unanimous opinion is that the Federal Reserve will increase interest rates for a second time at next week's Federal Open Market Committee meeting. The Fed rate hikes, coupled with a more optimistic economic outlook, have caused the yield on the 10-year Treasury to increase from 1.77 percent a month ago to above 2.4 percent today. At the same time, the U.S. dollar has appreciated nearly 5 percent against a basket of eight major foreign currencies since the end of September. The dollar strength threatens U.S. exports and will act as a drag on corporate America's revenue and profitability.

Will the triple whammy of higher energy prices, higher interest rates and a rising dollar represent a confluence of headwinds too great for the economy to withstand? Maybe not, but it sure seems like our near- to intermediate-term growth potential could be capped based on these factors. Without overreacting, we feel that there are ample reasons to be cautious.


Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.