Who Gets Hurt When Oil Falls
When the Organization of Petroleum Exporting Countries failed to cut production quotas last month, the initial investor reaction was: Hallelujah! Lots more savings for energy buyers! Blowout Christmas spending by consumers!
The celebrations may have been premature.
True, the $1 decline in U.S. gasoline prices since April is the equivalent of a 1 percent rise in consumer spending power. Of course, some of that may be saved and not spent, at least initially. And in countries with fixed fuel taxes, including China, the economic effect will be greater. At the same time, U.S. auto makers may benefit from increased sales of low-mileage SUVs and light trucks, which are highly profitable.
Net energy importers, including Japan, South Korea and other East Asian countries, also benefit from lower energy prices. China imports 60 percent of the 9.6 million barrels of oil it uses each day.
Other energy importers helped by lower prices include India, Turkey and Western Europe. Pakistan, Egypt, India and other countries that subsidize energy costs will be able to reduce those expenses. Some of the benefit, though, is offset because the euro and other currencies are weak and oil is priced in more expensive U.S. dollars.
But the list of oil losers may overpower the winners. Almost immediately, energy companies started to cut capital spending, which equaled 0.9 percent of U.S. gross domestic product in 2013, the largest share since the early 1980s. An index of oil-field service companies is down about 40 percent from its peak.
General Electric has acquired more than $14 billion in oil and gas businesses since 2007, and three months ago said its “base case assumption” included Brent crude oil at around $100 a barrel. Chief Executive Officer Jeffrey Immelt admitted that, with oil around $60, profits could be lower next year.
Also harmed are oil-sands producers in Canada, where a lack of transportation had pushed prices to $48 a barrel by late November, well below all-in production costs of about $85. Canadian Oil Sands, the largest owner of the giant Syncrude oil sands joint venture, plans to cut its dividend by almost half.
Also vulnerable are highly leveraged North American oil and gas producers. The 10 worst-performing energy companies in the Russell 3000 index have debt that is four times their market value. By comparison, the energy sector's average is 1.2 times.
Energy companies issued junk debt with abandon in recent years. Strained financial conditions may force weak energy producers and service companies to divest properties or sell themselves, yet buyers are likely to be scarce until energy prices stabilize. Many low-quality master limited partnerships in the energy area could be in trouble.
The weakness in junk bonds is spreading beyond energy-related issues as scared investors retreat. Since June, they have pulled $22 billion from junk-bond funds as they begin to realize they were further out on the risk curve than they wanted.
Also, post-financial crisis regulations are limiting banks' involvement in junk-security markets, removing their cushioning effect as providers of liquidity. Ditto for leveraged loans that banks often make to finance private-equity deals (and the subject of considerable worry at the Federal Reserve).
Overseas, grossly mismanaged oil producers, including Venezuela and Nigeria, are obviously in trouble. They need prices well above $100 a barrel to meet budget needs.
Russia, of course, is the poster boy for troubled oil exporters. Even before Russia’s central bank raised interest rates to 17 percent from 10.5 percent on Dec. 16, it said the economy could contract by as much as 4.7 percent next year if oil remained near $60.
With the 40 percent drop in the ruble this year pushing up import prices and higher interest rates increasing credit costs, inflation is set to rise. It already jumped 9.1 percent in November over the same month a year ago. No wonder Russian consumers are lining up to buy furniture, mobile phones and other goods before prices leap.
Adding in sanctions over Russia's invasion of Ukraine, Western European exports to Russia of autos, luxury goods and other discretionary items will suffer. Stock prices are anticipating this.
Russians are willing to take a lot of punishment. President Vladimir Putin’s approval rating remains at 80 percent and he has tremendous control over politics and the economy.
Still, he is playing to patriotism, blaming all of Russia’s troubles, including the sanctions over Ukraine, on foreign governments and speculators. As Shakespeare wrote in Henry IV, “Busy giddy minds with foreign quarrels.”
Russia's troubles have parallels with 1998, but only to a point. Back then, after the Asian financial crisis, Russia devalued the ruble by more than 70 percent over a few months and defaulted on its debt. To keep the crisis contained and to help the new democracy, the U.S. organized an International Monetary Fund bailout.
Unless Putin pulls back in Ukraine, there’s little Western zeal to aid Russia. So the prospects for another global financial crisis may be greater than in the late 1990s.
I’ve been looking for an economic shock to end the disconnect between soaring equity prices (fueled by central bank largesse) and limping economies. Since the 2008 financial crisis, central bank money has encouraged individuals, businesses and countries to borrow at low rates. The nosedive in oil and other commodity prices makes it hard to pay back those loans as deflation spreads worldwide and almost every currency declines against the U.S. dollar.
The U.S. stock market, while pointing up now, may yet have a negative response to declining energy costs, suggesting that the financial risks from falling oil prices may outweigh the benefits to consumers.
If a full-blown global financial crisis unfolds, along with an accompanying worldwide recession, investment strategy will no doubt shift from the current “risk on” stance to “risk off.” In that scenario, you would expect to see a rush into the safety of Treasury bonds and the U.S. dollar and a stampede out of commodities and stocks globally.
Interestingly, most of this is already in tow. Treasuries are rallying as Americans and foreigners pour in; yields recently hit 2014 lows. The dollar has been robust against the deliberately devalued yen and euro, as well as the currencies of commodity exporters Australia, New Zealand, Canada and Russia. And commodity prices, from oil to copper to sugar, are falling.
Only stocks remain to turn down decisively, and even that could change if oil prices keep sinking.
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