Not all is Good with Lower Oil Prices

4 mins. to read

by Filipe R. Costa

With two thirds of its exports generated by the energy sector, Russia gets into trouble every time oil prices decline. When I wrote about the issue two weeks ago, oil prices were around $80 a barrel and both the rouble and the equity markets were in free fall. But, in the meantime, and mostly as a consequence of OPEC’s decision to keep output unchanged, oil prices have lost another $10, contributing to further declines in equities and in the rouble.

In general, lower oil prices create large imbalances for oil exporters. But at the same time, they should benefit those who are net importers of the commodity. Lower oil prices reduce petrol and diesel prices and allow US and European consumers to increase spending on other products and services. Lower prices therefore boost consumption and economic growth. But globalisation complicates the equation and the nascent shale industry in the US can create a lot of trouble in debt markets, as companies become unprofitable. If prices continue to go down, 15% of the junk bond market will be in trouble, and the effects of large scale defaults in the industry may press the banking system at a time it is still fragile.

While the Saudis try to break Russia and Iran and undermine the US shale revolution, things can become really nasty and lead the world’s economy into further trouble. Just look at the equity market for clues. I’m not seeing much enthusiasm coming from lower oil prices, so something may be offsetting the consumer benefits.

When oil prices decline, consumers usually feel happier.

But that happens when prices decline a few cents here and there. A free fall in oil prices is usually the consequence of deteriorating economic conditions and thus shouldn’t be taken as a good thing but rather as a negative consequence of economic prospects. During the second half of 2008, oil prices plunged, and a financial crisis followed. I’m not saying the crisis was the consequence of the lower oil prices, but instead that lower oil prices are associated with recession and thus reflect poor economic conditions.

But this time the problem is different, as the declining oil price is more a consequence of a supply shock than of a lack of demand. Thus, low prices can’t be interpreted as the result of poor economic conditions. Again, I’m not saying demand is strong, as it really isn’t, but just that what matters the most in the current situation is the supply conditions.

High oil prices, low credit costs, and the introduction of new technologies over the last few years has allowed for the extraction of oil from difficult-to-drill places.

Oil companies in Texas and North Dakota are now using fracking and horizontal drilling as a means of extracting oil from unexplored places, which has increased oil production in the US to 9 billion barrels per day. That is a huge amount by both historical and geographical means, as it marks a 29-year high and represents almost 33% of OPEC countries’ output. In economic jargon, this increase in production has significantly shifted the supply curve of oil to the right and is therefore the main reason why oil prices need to decline.

Of course, a decline in prices could be prevented if OPEC reduces output.

But in doing so OPEC would be financing the shale revolution and exports from other geographic areas like Russia. In others words, OPEC countries would lose market share and carry the whole burden of the excess output generated by others. Most of these OPEC countries are now entering a situation in which they will run fiscal imbalances, but their debt-to-GDP is so low that they can very well tackle it. In the meantime they are happy to see the shale revolution go broke, and lead Russia into trouble. This is where trouble to the global economy starts.

Over the last few years, many resources were allocated into shale oil exploration in the US, particularly in Texas and North Dakota. Companies are highly leveraged and finance their projects with debt. Energy projects currently represent 15% of total junk bond issues. These companies are protected against any increase in interest rates, as most of them pay fixed interest rates, but they are not protected against a persistently weak backdrop for oil prices. If oil prices continue to decline or stay at these levels for long, these companies will see their cash flows erode. Many companies will default and projects will be terminated, increasing unemployment and adding pressure on banks and investors.

We should also not forget that it is not just the shale oil producers that will come under trouble. Any major energy company will experience a drag on profits, even if sitting on a sufficiently large cash pile to keep solvent for years. I believe the Saudis will take this price war seriously and that the shale revolution will be in real trouble. Oil stocks and oil ETFs, particularly those related to the US shale revolution, have been pressured down and will remain that way. I would not consider buying the recently created Unconventional Oil & Gas ETF (FRAK), as the enthusiasm that was built into its components will likely vanish at the time the next profit statements are released.

Comments (0)

Comments are closed.