“For anyone consuming oil, lower oil prices are a tax cut,” said U.S. Secretary of the Treasury Jacob Lew at the World Economic Forum in Davos on Jan. 21. “It puts more money in people’s pockets. It actually has a positive effect.” Lew was trying to be reassuring, with good reason. The day before, crude prices had dropped to a 12-year low of $26.55 a barrel, down from $107 as recently as mid-2014. The ripple effects in the stock market briefly wiped as much as 565 points off the Dow Jones industrial average. (Oil rallied back to $32 as of Jan. 27.)
Lew’s contention that dramatically cheaper oil is something to cheer about makes a lot of intuitive sense. China, the world’s largest oil importer, has capitalized on lower prices by stockpiling reserves; for all the country’s problems as its growth slows, energy costs aren’t among them. In the U.S., consumer confidence is on the rise. The benefits of the price cut “handily outweigh the negatives,” says Jacob Oubina, senior U.S. economist for RBC Capital Markets. “It’s just a matter of when consumers and businesses adjust to this.”
The meme that cheap oil acts like a tax cut goes back decades. As early as 1983, lawmakers asked the Congressional Budget Office to gin up estimates of the beneficial impact of falling prices. Revisiting the topic a few years later the CBO offered an instructive caveat: “It may be best not to refer to a ‘tax cut equivalent’ of an oil price change.” Among the reasons the analogy didn’t work: The drop in revenue for domestic energy companies can trigger economic contraction not seen with a tax cut. And, surprisingly, the total economic benefit actually shrinks the further prices fall.
Increased U.S. energy independence has made the math even trickier. With domestic output near a 43-year high and fuel imports down to 24 percent of consumption, a glut of crude isn’t a problem just for OPEC and Texas anymore. Third-quarter revenue for U.S. independents, the little companies that drove the shale boom, was $26 billion less than the year before, according to data compiled by Bloomberg. Last year’s spending is on track to be more than $60 billion lower than 2014, and oil at $30 a barrel has prompted a fresh round of cutting. Goldman Sachs, which hailed lower prices as a $125 billion tax cut in December 2014, put it this way in a November report retreating from its bullish prediction: “Shale states shrank the stimulus” that usually comes when consumers pay less at the pump.
Instead of tax cut, some analysts are turning to another simile: Falling oil prices could be like falling real estate values. “This was a Wall Street bet, and the bet was that the price of oil, a theoretically finite commodity, wouldn’t go below a certain level,” says Martin Bienenstock, co-head of bankruptcy and restructuring at law firm Proskauer Rose. “The bet turned out wrong. Just like the bet that housing prices would never fall.”
During the boom years, some shale producers spent $2 drilling for every $1 earned selling oil and gas, according to data compiled by Bloomberg, and they plugged the shortfall with debt. Wall Street extended low-interest credit lines to junk-rated borrowers, which put up their oil and gas properties as collateral. Producers tapped their bank lines to buy properties and drill wells. When companies needed to pay off their loans, their bankers helped them sell equity and debt. Investors, hungry for higher returns after years of low interest rates, snapped it all up.
From 2004 through 2014, the high-yield bond market doubled in size while the amount of bond debt owed by junk-rated energy producers expanded elevenfold, to $112.5 billion, according to Barclays. Bond buyers were so eager that provisions meant to protect them eroded.
It worked beautifully until oil prices collapsed. Revenue has plummeted, leaving producers short of cash to pay their debts. Banks have cut drillers’ credit lines as the value of their collateral has fallen. Oil and gas bonds have pushed debt market distress to levels not seen since the 2009 recession, according to Standard & Poor’s, and bond buyers are selling their holdings at steep discounts to salvage some part of their investment.
Those who got out could be the lucky ones. Last year 42 U.S. oil producers went broke owing $17 billion, according to the law firm Haynes & Boone, a trend that’s likely to accelerate at today’s prices. Many holders of those companies’ bonds will get nothing. Banks aren’t immune. Wells Fargo, Bank of America, Citigroup, and JPMorgan Chase said this month that they’ve set aside at least $2.5 billion to cover potential losses on souring energy loans. If low prices persist, the price tag will get bigger.
The worry is that the pain spreads from finance to the broader economy. “Consumers may be doing great until producers can’t service their debt,” says Michael Feroli, chief U.S. economist at JPMorgan. “And that creates problems for everyone, producers and consumers alike.” He points out that the commodity bust of the 1980s contributed to the inability of emerging-market countries to pay their debts, with worldwide consequences.
Oil-rich countries that spent the boom years collecting bonds, equities, department stores, and soccer teams are in selling mode. As they dump assets, exacerbating the market rout, “it feels pretty messy,” wrote David Zervos, chief market strategist for Jefferies Group, in a Jan. 18 report. Saudi Arabia, the world’s largest oil producer, has seen its foreign exchange reserves fall by more than $100 billion since mid-2015, according to the Saudi Arabian Monetary Agency, a bigger drop than during the financial crisis.
“But outside the energy market, this is nothing like 2008,” Zervos added. “This crash is a huge transfer of wealth away from the levered global energy asset holder to the unlevered average consumer.” Similarly, RBC’s Oubina calls comparisons to the subprime bust “insanity.” The financial system, he says, “is ironclad compared to 2007.”
There’s one more thing low oil prices might be like: a flashing red warning light. China’s downshift to annual growth of 6.8 percent, from 10 percent five years ago, is a big factor pulling oil prices down. It points to an increased risk of deflation and slow growth throughout the global economy. In other words, persistently low oil prices could really be just a symptom, says JPMorgan’s Feroli. “This may be the result of a bad economy,” he says. “Not a cure for a bad economy.”
The bottom line: While cheap oil has benefits for consumers, defaults by producers and pain in oil-rich countries could stall the world economy.