Lower oil prices, which lead to lower gas prices, are good for the American economy – like a “tax break” for the consumer – or so the story goes. Paying less at the pump leads to more money in your pocket, which results in more discretionary spending (read: buying things) and greater GDP. It is a nice, simple explanation of the economics of lower oil and gas prices. And it is true, lower oil prices does lead to more money in people’s pockets. Unfortunately the simple, one sentence explanation is almost never the correct analysis. We live in a world of intricacies with complex economic relationship.
The U.S. economy is more than just consumers, but also energy producers. In the past 5 years we have become one of the largest global producers of oil, now pumping out 9 million barrels of oil per day. This production, and any change in the amount of that production, affects not just the producers of the oil, but the companies that supply the industry. This includes not only the direct suppliers like the oil services companies, but also the local businesses that serve workers lunch, sell them their work clothing, and provide them entertainment in their off hours. A decade ago, before fracking, this was just not the case.
Up to this point the new production has been a boon for U.S. GDP. In Wyoming and the Dakotas the unemployment rate is extremely low while the new jobs created are generally well paying. This is great, for sure. The economic risk to this story is tied to the reality that much of the new oil production is “high cost” production. Because it is high cost this production is also marginal in nature.
Recent surges in production in the U.S., Iranian and Syrian supply reentering that global marketplace, and little reason to believe there will be a cutoff in supply somewhere, has resulted in a steady oil market with plentiful supplies. More supply equals lower prices. OPEC (the Organization of the Petroleum Exporting Countries), and specifically Saudi Arabia, have for decades controlled global oil prices by rationing oil production within their own borders. With their dominance of the global oil markets being threatened by U.S. shale production, the Saudis blocked an OPEC production cut, much to the dismay of some of its partners.
Back in America this is both good and bad for the economy. Good because of the aforementioned extra money in the pocket of consumers. The possible negative consequences list is a bit longer and more complicated.
Most everyone is aware of the big oil producing companies like ExxonMobile and ConocoPhillips who have the financial capabilities to survive a period of lower oil prices. There are, however, a good number of companies in this space that are highly leveraged, lower quality companies, with a business model based on a higher market price for the oil they produce. At best these companies will be financially stressed. At worst extended weak pricing could cause bankruptcies. No matter the company involved, with oil production being unprofitable at current oil prices in the Bakken and Permian Basin, new projects in these areas are likely to be delayed indefinitely. This directly effects U.S. GDP growth as well as the job market.
Investors are affected as well. Over the last week of November energy company stocks sold off as did oil prices on the news that OPEC would not be cutting production. While this has a direct impact on the equity markets, of greater consequence is the negative influence this could have on the bond markets.
Currently, more than 15% of the high yield (junk) bond market is composed of energy companies. Blogger Josh Brown lays out the challenge for markets.
It is well-known that:
- investors chasing yield have plowed into junk bonds in recent years, with many credit market neophytes accessing the sector using ETFs with a limited operating history and an unknown liquidity profile – they’ve never really been tested before in a bond bear market.
- this chasing of yield has occurred on an institutional level as well, and the end result has been an ocean of liquidity for any issuer who showed up wearing a clean suit. So-called “covenant-light” deals – which give issuers even more latitude with their balance sheets – have become the rage recently as the desperation for income stretched into a seventh year.
- all of this high yield liquidity – aided and abetted by the Fed – has engendered an almost consequence-free environment for all participants: Defaults are at generational lows and everything is being priced off the Treasury yield, which never goes up.
- refinancing and buyback activity have created a massive wave of multiple expansion – some estimate that almost all of the market’s recent gains can be chalked up to shrinking share counts and the earnings-per-share growth they create.
Back to the original question: Are lower oil prices good or bad for the markets and the economy?
It depends on how long the lower oil prices persist. If this is a short-term blip then things should go back to “normal” in due time. With oil prices back in the $90-$100range, the current lull in new energy development would surely come to an end. Car sales may suffer in volume and profitability – less buying of the higher margin trucks and SUVs – but likely remain strong. And the consumer would continue to buy, just not as much.
On the other hand, if oil prices remain low for an extended period, the consumer will have a lower cost for many things, most notably travel and home heating. Of course this is a good thing, allowing for more discretionary spending as well as happier people in general. The dark side, we fear, is lower corporate earnings in the energy sector, lower capital spending on developing new energy sources, and a stressed bond market. Unfortunately, we do not see a scenario where the additional profits produced from additional consumer spending would off-set the lost energy profits. Goldilocks does not exist.
Now is not the time to make a bold move with your investments. Take caution not dramatic motion until oil prices stabilize and the situation becomes clearer.
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