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Enjoy Cheap Oil, Fear the Deflation

A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.
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My last column explained the dangerous game of chicken Saudi Arabia is playing with other major oil producers, including U.S. frackers, to see who can withstand low oil prices the longest before slashing production. That price may be as low as $10 to $20 a barrel, or even lower. Now let's look at how things might shake out. 

Start with the winners from the faceoff, which include the U.S. in general -- the country still imports more than a quarter of its energy needs -- and American consumers in particular. The 40 percent drop in gasoline prices from their recent peak of $3.70 a gallon in April 2014 has given drivers about a 1.7 percent boost in purchasing power. So far, most of that has been saved, though consumers probably will increase their spending if oil prices stay low. 

Oil Prices

Perhaps no industry is more sensitive to oil prices than airlines, since fuel is their largest single cost. Senior officials at American Airlines, United Continental and Delta say the halving of fuel costs will go straight to the bottom line to benefit stockholders and provide funding for stock buybacks. Southwest plans to accelerate its growth if fuel costs remain low. Shares of the major carriers have surged since October. However, airline passengers, not stockholders, will probably be the final winners because of the tight correlation between fuel prices and fares. 

Japan and other Asian energy importers also will benefit from lower prices. So will importers in Western Europe as well as Turkey, Pakistan, Egypt and India. Nevertheless, oil is priced in dollars, and the weakening of most currencies against the greenback offsets some of the effects of dropping crude prices.  Also, amid falling energy prices, Japan has raised auto-fuel taxes so pump prices are down only 15 percent there. Brazil, meanwhile, has used declining energy prices as an opening to cut fuel subsidies and raise taxes. China imports about 60 percent of the 9.6 million barrels it uses each day, but falling oil and other commodity prices harm that country's energy, mining and metals-processing businesses as capital spending is slashed. 

Losers from falling oil prices obviously include U.S. producers and oil-services companies, especially those that took on large amounts of high-yield debt during the oil-price boom. Energy companies account for 17 percent of the junk bonds outstanding, and the securities are leading the way down as prices fall, yields rise and spreads widen versus Treasuries. Only $13.4 billion in junk bonds was issued in January compared with $22.7 billion a year earlier. 

Oil and gas-related capital spending accounts for just 1 percent of U.S. gross domestic product, but the industry already is cutting costs. Employment in the U.S. oil and gas industry leaped 29 percent from the end of the recession in 2009, more than triple the overall job gain of 8.6 percent. The industry retrenchment will be painful. 

Shares of exploration and production companies are down about 40 percent since last summer, while the energy giants -- Royal Dutch Shell, Exxon Mobil, Chevron and BP -- are down by about a quarter. Their production and exploration costs are low, in the $20 to $30 a barrel range, and the refining and distribution arms of these integrated outfits benefit from cheap crude. They also tend to have time horizons of 20 years or longer for capital projects. Still, they’re all cutting spending to preserve cash flows and dividend payments, which suggest they think low oil prices will be around for a long time. BP Chief Executive Officer Robert Dudley said recently that U.S. shale-oil production and low oil prices are a structural shift that is forcing him to “reset the whole cost basis of the company.” 

Among the hardest hit are those nations that rely on oil for much of their government revenue and were in financial trouble before prices plunged. Venezuela along with its state-run oil company issued more debt than any developing country between 2007 and 2011. Venezuela has been downgraded to the bottom of the junk pile -- CCC by Fitch -- and credit-default swaps on Venezuelan debt recently indicated a 61 percent chance of default in the next year and 90 percent in the next five years. The nosedive in oil prices also is devastating African exporters Ghana, Angola and Nigeria, where oil finances 70 percent of the government’s budget. 

Another country in trouble is Russia, where Western sanctions over Ukraine and tumbling oil prices are threatening it with a rerun of its 1998 default. The ruble swooned 43 percent in 2014 and sanctions prevent Russian banks from borrowing abroad to service their foreign debts. The Russian central bank jacked up interest rates to 17 percent to fight inflation, now running at 15 percent, but then had to cut them to 15 percent to try and prevent a deep recession. 

On balance, energy consumers win and energy producers and exporting countries lose. Yet two important questions remain. Will energy-driven deflation, now in evidence in almost half of the 34 major developed countries, spread to prices in general? If so, will that encourage potential buyers to wait for still-lower prices in a self-reinforcing spiral that spawns more deflation and slow, if any, economic growth? In today’s world, with so many weak and troubled economies, general and chronic deflation is likely. 

Second, will the fallout from deleveraging in the energy industry worldwide spawn a major shock and global recession that shifts the investment climate from “risk on” to “risk off”? As with the financial excesses revealed by the housing collapse, there’s probably much higher leverage among energy-related companies and countries than is now apparent. As Warren Buffett once said, you don’t know who’s swimming naked until the tide goes out.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
A Gary Shilling at insight@agaryshilling.com

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net