6 Reasons Why Oil Prices Are Causing Anxiety

January 28, 2016

Are low oil prices good for the economy? This week, West Texas Intermediate and Brent Oil are both trading at about $30 a barrel. There are a lot of commentators out there who make the claim that the low price of oil acts very much like a tax cut. The question of the day is, really, is that the case?

Are low oil prices good for the economy?

 

One rule of thumb that was recently revealed in The Economist states that a 10% drop in the oil price boosts economic growth from 0.1% to 0.5%. In the past 18 months we’ve seen a 72% drop in price, from $110 all the way down to $30. We certainly haven’t seen an associated boost. Why is such a large drop in the price of oil such a great cause of anxiety? Why is it a cause of angst? There are six reasons. I’m going to briefly enumerate them.

 

First, we’re looking at collapsing revenues within the industry. At the nation-state level this adds to significant instability for some producer countries that really can’t afford it. Gulf states in particular, but also Venezuela and even Russia, are under enormous pressure and experiencing political instability due to these lower oil prices.

 

Second, an interesting feature of the American consumer that’s changed since the great recession is that Americans now are more prone to save their windfalls. Not all of those savings are finding their way back into the economy. They’re actually being saved or being used to pay down debt.

 

Third, the oil producers are cutting spending dramatically. So are the service companies, and so are the pipeline companies. There has been an enormous drop-off in demand of high-value production and distribution industries. That’s manufacturing; that’s jobs out in the rigs. It’s been significant. It has resulted in the loss, in the United States alone, of literally hundreds of thousands of jobs.

 

Fourth, there’s a significant debt overhang in many areas of the industry, among both nation-states and individual producers. This is causing production to stay at a high level despite the fact that it makes no economic sense to actually go out and look for more resources. It’s not a profit issue. It’s a survivor issue, which is why this will continue until some of these firms, and unfortunately maybe even some of these countries, start to fail.

 

The fifth issue that we’re facing is risk aversion within wealthy nations, spreading not just throughout the oil industry but into the financial markets. We’ve seen the volatility in the spike. We’ve seen the last six weeks of market turbulence. On the bond side of the fence we’re actually seeing more subtle, but maybe even more significant, changes. The pipelines are yielding into the teens, occasionally even the 20% range. High-yield debt, even debt that’s not related to the energy industry, is starting to pay 6%, 7%, 8%. As an asset allocator, we’re actually excited that maybe in the next three or four months it will make sense to bring that back into the model, even though we haven’t looked at high-yield bonds in many years.

 

Finally, the sixth element that’s affecting us is low inflation. This fall in the price of energy is putting downward pressure on prices throughout the economy. Already inflation is extraordinarily subdued. Yellen recently increased interest rates at risk to the economy, just so there would be the ability to lower those interest rates should inflation turn negative. A negative inflation is actually devastating for an economy. Japan went through 20 years of deflation. It was very difficult to get out. There is this danger of deflation if these low oil prices maintain.

 

With an oil shock coming in the wake of the recovery from the Great Recession—along with low fundamental yields and low inflation—it is not at all clear that what’s happening today is good for the economy. For once, maybe we should all be hoping for higher prices at the gas pump.

 

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