Over the span of the last 7 months oil has fallen by over 40% and the bottom is still nowhere in sight. What has caused this epic decline and what are the implications, both financial and social, to the US and global economies?
On June 25, 2014, WTI (West Texas Crude Oil) was $102.53/barrel. Today, December 16, 2014, oil is trading under $56/barrel. The price of gasoline at the pump has fallen accordingly. One year ago the national average for a gallon of regular gas was $3.23/gallon. Yesterday that average had fallen to $2.53/gallon. The implications for US consumers is obvious. Gas price increases or decreases are widely considered either a tax or tax break for US consumers. In this case the decline at the pump is being described as a massive tax break for consumers. The questions most analysts are trying to answer is: "Are consumers spending more elsewhere now that they are experiencing some relief at the pump?"
Why Oil Prices Are Declining
Oil prices are delining because:
- Global demand is declining
- The US is producing an abundance of shale oil and gas
- Speculation in energy markets has soured
- OPEC refuses to adjust productions to today's market realities
Do the Benefits Outweigh the Costs?
Wait a minute, what costs? This is where things get cloudy for most people. How can there be costs associated with lower oil? Aren't lower oil prices a win-win for all involved? The short answer is "No." Those that sell oil and work in related fields suffer when the price of oil falls, not unlike purveyors of any product that falls in value. The tricky thing about oil is the broad benefit lower prices can have for all consumers and thus its potential economic impact nationally. The clue to whether consumers are increasing their discretionary spending to other areas could be found in the government's retail sales figures. Sales naturally will fall in the "service station" category and should increase in other categories. Will those increases be statistically significant? Will those possible increases help stimulate a moribund economy that is experiencing subpar growth for a "rebounding" economy? About those costs? A significant portion of the US economy is comprised of the energy sector. Those companies that rely on selling oil at a certain price based on their costs are adversely affected by falling prices. At some point lower prices cause these these companies to lose money which ultimately will hit their bottom lines. The result are falling stock prices and cut backs resulting in job losses and the elimination of exploration and drilling, as these become less viable endeavors to pursue.
Wall Street's biggest fear is the possible contagion associated with the banking sectors record amount of lending to the energy sector amounting to $465 billion, up 29% from the prior record in 2007, just before the "great recession". If these loans deteriorate the broader ramifications could be serious. Already equity markets are reflecting Wall Street's angst, with the S&P 500 down 3.5% this month. Flight to safety is showing up in higher bond prices, pushing the US 10-year treasury down to 2.06%. Where does this end? Presumably when oil stops falling.
The Social Implications
The reality is the social implications of falling oil are related to the financial implications. As nations (Russia and Venezuela, most notably) and individuals struggle financially from falling oil the spillover is social. Unrest has already been reported in Venezuela and how long until Russia experiences similar ills? Venezuela relies on oil revenues to make debt payments, which are coming due early next year. Putin and Russia are being simultaneously squeezed by falling oil revenues and US sanctions. How long until things break? Ostensibly, Russia has brought this on itself with its ongoing conflict with the Ukraine. Will they learn a lesson? Putin strikes me as particularly bull-headed. I would not count on him to throw in the towel for an extended amount of time, maybe when it's too late.
The Analysts' Spin
It is well understood that money managers and market analysts can never be outdone when it comes to market sanguinity, but even their "spin" is wearing thin...on each other. The story: When oil prices are rising it's because of strong global growth and markets cheer and rise. Today, while oil prices fall it's a boon for consumers and retail sales will benefit and markets cheer and rise. These stories are spooned to us from the same people. Are they speaking out of both sides of their mouths? Yes and no. Their explanation is that oil's decline is different this time. Have you heard that before? So have I. Their explanation is that oil's decline is not due to weak growth, it's due to how great America is at producing and using energy. Ok, that's fair. But, oh by the way, why is there a glut all of a sudden in oil? None of them deny that global growth has slowed and overseas demand is down. The magic wand they are using is "decoupling", that is what the US is doing. Therefore, we are immune to the global ills affecting the rest of the world. Don't believe it. We are part of the global economy and we are not immune to the world's problems. When the world coughs we will still catch a cold.
The Black Swan - No, it's NOT oil, it's actually Deflation!
I was being cute there. Sure it's oil's price decline that is the problem, on the surface. But it's really what the decline represents that is so debilitating in today's environment. Falling prices represent deflation and deflation is the enemy of capitalism and all those that live by its tenets. I have documented fully the evils of deflation on this blog but to reiterate: when prices fall people put off spending, companies can't make a profit and don't increase capital expenditures or hire people. It's nasty stuff to be sure.
The Bottom Line
As analysts come around and slowly concede that falling oil is not a completely benign event, they are assuring us that in the long run its benefits will outweigh its near term costs. I have a tendency to believe them in this regard. Given enough time, markets will acclimate to lower oil and markets will find equilibrium. This is true under any new circumstance. This is what markets do. They adjust to new realities and move on with a new calculus. This is what makes markets great. You will find few people who would argue this point.
For the time being, look for lower rates, lower commodities, and lower stocks.
Wall Street's biggest fear is the possible contagion associated with the banking sectors record amount of lending to the energy sector amounting to $465 billion, up 29% from the prior record in 2007, just before the "great recession". If these loans deteriorate the broader ramifications could be serious. Already equity markets are reflecting Wall Street's angst, with the S&P 500 down 3.5% this month. Flight to safety is showing up in higher bond prices, pushing the US 10-year treasury down to 2.06%. Where does this end? Presumably when oil stops falling.
The Social Implications
The reality is the social implications of falling oil are related to the financial implications. As nations (Russia and Venezuela, most notably) and individuals struggle financially from falling oil the spillover is social. Unrest has already been reported in Venezuela and how long until Russia experiences similar ills? Venezuela relies on oil revenues to make debt payments, which are coming due early next year. Putin and Russia are being simultaneously squeezed by falling oil revenues and US sanctions. How long until things break? Ostensibly, Russia has brought this on itself with its ongoing conflict with the Ukraine. Will they learn a lesson? Putin strikes me as particularly bull-headed. I would not count on him to throw in the towel for an extended amount of time, maybe when it's too late.
The Analysts' Spin
It is well understood that money managers and market analysts can never be outdone when it comes to market sanguinity, but even their "spin" is wearing thin...on each other. The story: When oil prices are rising it's because of strong global growth and markets cheer and rise. Today, while oil prices fall it's a boon for consumers and retail sales will benefit and markets cheer and rise. These stories are spooned to us from the same people. Are they speaking out of both sides of their mouths? Yes and no. Their explanation is that oil's decline is different this time. Have you heard that before? So have I. Their explanation is that oil's decline is not due to weak growth, it's due to how great America is at producing and using energy. Ok, that's fair. But, oh by the way, why is there a glut all of a sudden in oil? None of them deny that global growth has slowed and overseas demand is down. The magic wand they are using is "decoupling", that is what the US is doing. Therefore, we are immune to the global ills affecting the rest of the world. Don't believe it. We are part of the global economy and we are not immune to the world's problems. When the world coughs we will still catch a cold.
The Black Swan - No, it's NOT oil, it's actually Deflation!
I was being cute there. Sure it's oil's price decline that is the problem, on the surface. But it's really what the decline represents that is so debilitating in today's environment. Falling prices represent deflation and deflation is the enemy of capitalism and all those that live by its tenets. I have documented fully the evils of deflation on this blog but to reiterate: when prices fall people put off spending, companies can't make a profit and don't increase capital expenditures or hire people. It's nasty stuff to be sure.
The Bottom Line
As analysts come around and slowly concede that falling oil is not a completely benign event, they are assuring us that in the long run its benefits will outweigh its near term costs. I have a tendency to believe them in this regard. Given enough time, markets will acclimate to lower oil and markets will find equilibrium. This is true under any new circumstance. This is what markets do. They adjust to new realities and move on with a new calculus. This is what makes markets great. You will find few people who would argue this point.
For the time being, look for lower rates, lower commodities, and lower stocks.
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