Are you wondering why financial markets are reacting negatively to the price of oil being too low? Shouldn’t an oil price around $30 a barrel be a good thing? After all, cheaper pump prices mean consumers have more to spend elsewhere.
We’ve discussed the factors that are contributing to market volatility many times. They include a transitioning Chinese economy (as we covered last week), a glut of money thanks to Central Bank Quantitative Easing and a glut of oil. Well this time around… a low oil price is spooking markets, and here’s why.
Demand for oil has grown hand-in-hand with the industrial revolution of the 19th Century. Names like Rockefeller dominated the American landscape, World War 1 increased demand and a search for other jurisdictions with oil supply ensued.
The Organisation of the Petroleum Exporting Countries (OPEC) was formed in the 1960’s originally by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela in order to coordinate petroleum policies, and price. Other producers later joined, including other Middle Eastern, African, and South and Central American nations. The US, North Sea, and Soviet Union/Russia were never a part.
The laws of supply (controlled in the most part by OPEC) mixed with consistent and growing demand meant price was easy enough to control.
This chart (while a little dated), maps events in history with the oil price. The oil price managed to peak at around $140 a barrel in 2008, which also coincided with China’s peaking industrialisation. At $140 p/b… it suddenly makes the economics of some forms of alternative energy, as well as previously unviable fields compelling.
Technological developments allowed Canadian and Russian oil sand projects, and North American shale to come into production.
These companies borrowed money from banks and bond markets to bring their discoveries to market.
The US and Russian production managed to break the stranglehold OPEC had on the market. Since 2013, US production grew 19%, compared with OPEC at 4.5%. At the same time, China’s economy slowed from a 10% annualised growth rate, to around 7% – meaning less demand for this excess production. A supply glut followed, and price buckled from ~$100p/b to the current ~$30p/b.
As the price collapsed, US rigs either went slow, or have been taken offline. It’s estimated some $380b of new projects around the world have been scrapped.
That all sounds simple enough, but remember a number of companies borrowed a lot of money to set up production a few years back. With heavy debt loads, some of these companies are pumping out even more oil to generate enough cash to pay down debts. Countries like Russia and Saudi Arabia are also pushing supply, as they too have debts to pay.
With the oil price at current levels, ratings agency Standard & Poors believes some $180b of debt is at default risk. They estimate some 50% of debt issued by oil companies is at risk.
S&P is not necessarily referring to the blue chip companies operating in this space, rather the marginal producers that have accessed the high yield or junk bond markets.
Yes – if you are a consumer.
No – if you are a producer.
It’s estimated lower pump prices will in effect put an extra $108 billion into US consumers’ pockets, lifting disposable personal income. With the US producing around 14.7m barrels a day, and consuming 19.6 mbd – it should be a net positive for the economy.
In Australia, it is expected to add 0.4% to growth.
The Eurozone imports about 50% of its energy use. With oil prices dropping 75% in 18mths, the costs of imports has fallen. This puts downward pressure on inflation, which would normally be good… but combined with money printing (QE) and negative interest rates, it is risking deflation.
From an economic standpoint, the major developed economies stand to benefit from a weaker oil price. Costs of production for industry fall, as do pump prices – which allow consumers to spend elsewhere.
What is worrying markets however, is the amount of debt in junk bond markets linked to oil or oil related emerging markets that are heading into distress, and potentially default. The risk of deflation is also rising with falling commodity prices, and with the money printing efforts and policies of some central banks.
Oil price, deflation, and possible junk bond defaults are building a witch’s brew for markets.
