Oil prices have fallen by more than 70 percent since mid-2014, and it seems unlikely for them to rebound for the rest of 2016 as global stockpiles, especially in the U.S., continue to accumulate. Consumers have benefited with an effective tax cut; producers struggle to generate turnover (let alone profit), and the recent rout in financial markets seems unlikely to halt. What makes this bout of low oil prices questionable is its downward persistence and forecasting uncertainty, all of which is occurring against a backdrop of diverging global macroeconomic conditions and bearish expectations.
The Economist wrote an article in January citing two possible reasons for why share prices decline when oil prices fall:
- Either the markets are challenging long – held assumptions about the economic benefits of low energy prices.
- Or global economic growth is so anaemic that an oil glut will do little to assist this.
The first point seems to base its reasoning on the idea that when oil prices fall, input prices (costs) fall, which would increase the free cash flow of companies, the proceeds of which can be used to generate shareholder value and increase share prices. The second point suggests that this effect is not strong enough.
But this view is too one–dimensional as it ignores the fact that the oil and gas sector is itself a major industry. One which is in the fulcrum of consuming raw materials and services as well as being the basis for producing inputs for manufacturers and households. When oil prices fall, oil and gas companies suffer profit losses. And since most of the assets in this sector are capital assets, which are highly illiquid, firms lack cash on hand (or cash equivalent assets) and are forced to make immediate cuts.
Leveraged companies are experiencing financial distress as debt becomes harder to service, reflected in high yield markets which have gone from 6.5% in mid–2015 to just under 10% last month. Also, capital expenditures and fixed asset financing have declined. The International Energy Agency estimates spending on oil exploration and production fell by 20% in 2015. Wood Mackenzie, the energy consultant, said approximately $380bn worth of oil projects were suspended in the same period.
This drag from low oil prices was picked up by Paul Krugman, arguing a small drop in oil prices (10–20%) would lead to the benefits of lower costs for firms, higher profits, etc. But due to the decline in oil and the rapid pace at which it has occurred, there is a non-linearity in firm behaviour and a process of industry-wide deleveraging begins.
Such a shock to any industry, irrespective of non-linear behaviour, would certainly disrupt the capital structure of industry.
Volatility as a new norm
Falling asset prices and investment levels are all the worse against the backdrop of a fragile global economy. Equity and oil markets have both lost their anchors, the Fed and OPEC respectively, and are now unhinged markets which are decoupled from fundamentals.
The sudden drop in oil prices has driven knee-jerk volatility from financial markets as central banks are no longer united in shoring up stock markets or in repressing financial volatility. This only adds to the risk of contagion in the real economy via negative wealth effects (assets prices fall, consumers feel less wealthy today than they did yesterday. Therefore they reduce their spending today).
Consumers, savers or both?
Lower oil prices were supposed to act as a short–run stimulus by increasing real incomes, from which the additional amount gained would be spent on further consumption. Thus, a fall in the price of oil represented a redistribution of money from the producer to the consumer.
To an extent, this did occur. A report from JP Morgan in October 2015 showed both high and low-income groups increased consumption of gasoline given its low price (see graph below). And people spent roughly 80% of their savings from lower gas prices.
Yet recent figures from the Department of Commerce show since the oil price fell, household yearly spending on gasoline and energy products has fallen by $155bn. But savings grew by $121bn. A recent Reuters/Ipsos poll showed 75% of Americans said the extra money did help with basic needs but most did not plan any additional spending from their usual budget. So why aren’t Americans spending all their extra income, leading to the short-run stimulus many of us predicted? Most likely due to poor wage and economic growth. Seeing consistently weak growth will eventually erode consumer and business confidence and make people less willing to spend.
This reluctance to spend threatens the U.S. to join their European and Japanese counterparts in deflationary territory. Having consumers postpone their purchases, in the expectation of lower future prices, is worrying given that consumption makes up the dominant component of most developed economies edifice.
Finally, weak global growth and low oil prices will continue to act as a major disincentive in the aim of using renewable fuels and acting on climate change, especially following December’s COP 21 agreement. Had oil prices not fallen so fast, then oil would be providing most Western economies with that boost we expected.
But given weak macroeconomic conditions, the rapid and deep fall in oil prices, the oil and gas sector and dependant industries in the supply chain have been majorly disrupted with no time to adjust to new market conditions. It seems the benefits of cheap oil are now outweighed by its costs.