Downside of Falling Oil Prices

I.C. Angles Investment Post…

Business journalists are celebrating the approximately 40 percent decline in oil prices from their June highs, as a positive development for the economy. Their reasoning is simplistic. Lower oil prices mean more money in the pockets of consumers, which means more spending by Americans and hence more economic growth. But three other factors argue that falling oil prices actually represent a net negative for the U.S. economy, despite the positive of American consumers spending less on energy.

Lower oil prices indicate lower global economic growth

The drop in oil prices is not being driven by a sudden rush of new supply into the market. Rather, the drop is being driven by declining consumption and expectations for further drops, due to a slowing global economy. Economic activity is falling in China, Europe and elsewhere. A decelerating global economy is a negative development for a U.S. economy already exhibiting weak growth, which only appears strong when compared to recessionary economies. The view that the U.S. will decouple from the global economy and not feel much effects from its slowing, is wide spread and likely overly optimistic. Falling oil prices, especially when combined with the bearish signals other equity, commodity and bond markets are sending, should be viewed ominously, even as the S&P 500 makes new highs. The oil market, now joins other markets, in sending a clear signal that the global economy is slowing, rather than accelerating, and that is decidedly bad economic news.

 

Job losses from falling oil prices will be felt in the U.S.

Those states with the strongest job creation have been linked to the shale oil boom, and estimates credit the energy sector with a significant role in the creation of new jobs, during this economic recovery. Shale job creation in particular has had a significant multiplier effect. Jobs have been created in exploration, the production of the requisite capital equipment, as well as supporting jobs in the transportation and service sectors. Shale exploration is particularly capital intensive, requiring continual drilling, as wells go dry at faster than expected rates. In addition, shale exploration has a higher extraction costs than more traditional methods, which means global job losses are likely to fall disproportionately on the American energy sector. Many commentators have speculated that by maintaining current production levels in the face of falling prices, the Saudis mean to drive American shale companies out of the market by making them unprofitable. The related losses will be concentrated around relatively high-paying jobs, rather than the part-time or minimum-wage jobs that have made up so much of the current cycle’s employment growth. Up until now, shale has been about the only thematic bright spot in terms of blue collar job creation in the American economy.

 

Impact on credit markets will be?

No one really knows the full impact falling energy prices will have on credit markets. We do know that in the U.S. junk bond market, energy companies make up a disproportionate share.  So, falling energy prices are not going to be good news for the junk bond market. We also know that shale energy has come in for a lot of criticism for being a Ponzi scheme reliant on cheap debt financing to dig wells, whose productivity falls off quickly and in some cases are not viable long-term investments. In fairness, due to the opaque nature of a lot of the finances and operations of these companies, we don’t know how dependent the industry at large is on how high oil prices and cheap debt. But we’re going to find out. We also don’t know the full global impact across credit markets, as also opaque trades and debt deals, structured around the certainty of higher oil prices, come apart. Only time will tell the magnitude of the downside, but lower energy prices are going to also be a negative development for credit markets.

 

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