Anyone That Believes That Collapsing Oil Prices Are Good For The Economy Is Crazy
Are much lower oil prices good news for the U.S. economy? Only if you like collapsing capital expenditures, rising unemployment and a potential financial implosion on Wall Street. Yes, lower gasoline prices are good news for the middle class. I certainly would rather pay two dollars for a gallon of gas than four dollars. But in order to have money to fill up your vehicle you have got to have an income first. And since the last recession, the energy sector has been the number one creator of good jobs in the U.S. economy by far. Barack Obama loves to stand up and take credit for the fact that the employment picture in this country has been improving slightly, but without the energy industry boom, unemployment would be through the roof. And now that the “energy boom” is rapidly becoming an “energy bust”, what will happen to the struggling U.S. economy as we head into 2015?
At the start of this article I mentioned that much lower oil prices would result in “collapsing capital expenditures”.
If you do not know what a “capital expenditure” is, the following is a definition that comes from Investopedia…
“Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to building a brand new factory.”
Needless to say, this kind of spending is very good for an economy. It builds infrastructure, it creates jobs and it is an investment in the future.
In recent years, energy companies have been pouring massive amounts of money into capital expenditures. In fact, the energy sector currently accounts for about a third of all capital expenditures in the United States according to Deutsche Bank…
US private investment spending is usually ~15% of US GDP or $2.8trn now. This investment consists of $1.6trn spent annually on equipment and software, $700bn on non-residential construction and a bit over $500bn on residential. Equipment and software is 35% technology and communications, 25-30% is industrial equipment for energy, utilities and agriculture, 15% is transportation equipment, with remaining 20-25% related to other industries or intangibles. Non-residential construction is 20% oil and gas producing structures and 30% is energy related in total. We estimate global investment spending is 20% of S&P EPS or 12% from US. The Energy sector is responsible for a third of S&P 500 capex.
These companies make these investments because they believe that there are big profits to be made.
Unfortunately, when the price of oil crashes those investments become unprofitable and capital expenditures start getting slashed almost immediately.
For example, the budget for 2015 at ConocoPhillips has already been reduced by 20 percent…
ConocoPhillips is one of the bigger shale players. And its decision to slash its budget for next year by 20% is raising eyebrows. The company said the new target reflects lower spending on major projects as well as “unconventional plays.” Despite the expectation that others will follow, it doesn’t mean U.S. shale oil production is dead. Just don’t expect a surge in spending like in recent years.
And Reuters is reporting that the number of new well permits for the industry as a whole plunged by an astounding 40 percent during the month of November…
Plunging oil prices sparked a drop of almost 40 percent in new well permits issued across the United States in November, in a sudden pause in the growth of the U.S. shale oil and gas boom that started around 2007.
Data provided exclusively to Reuters on Tuesday by industry data firm Drilling Info Inc showed 4,520 new well permits were approved last month, down from 7,227 in October.
If the price of oil stays this low or continues dropping, this is just the beginning.
Meanwhile, the flow of good jobs that this industry has been producing is also likely to start drying up.
According to the Perryman Group, the energy sector currently supports 9.3 million permanent jobs in this country…
According to a new study, investments in oil and gas exploration and production generate substantial economic gains, as well as other benefits such as increased energy independence. The Perryman Group estimates that the industry as a whole generates an economic stimulus of almost $1.2 trillion in gross product each year, as well as more than 9.3 million permanent jobs across the nation.
The ripple effects are everywhere. If you think about the role of oil in your life, it is not only the primary source of many of our fuels, but is also critical to our lubricants, chemicals, synthetic fibers, pharmaceuticals, plastics, and many other items we come into contact with every day. The industry supports almost 1.3 million jobs in manufacturing alone and is responsible for almost $1.2 trillion in annual gross domestic product. If you think about the law, accounting, and engineering firms that serve the industry, the pipe, drilling equipment, and other manufactured goods that it requires, and the large payrolls and their effects on consumer spending, you will begin to get a picture of the enormity of the industry.
And these are good paying jobs. They aren’t eight dollar part-time jobs down at your local big box retailer. These are jobs that comfortably support middle class families. These are precisely the kinds of jobs that we cannot afford to lose.
In recent years, there has been a noticeable economic difference between areas of the country where energy is being produced and where energy is not being produced.
Since December 2007, a total of 1.36 million jobs have been gainedin shale oil states.
Meanwhile, a total of 424,000 jobs have been lost in non-shale oil states.
So what happens now that the shale oil boom is turning into a bust?
That is a very good question.
Even more ominous is what an oil price collapse could mean for our financial system.
The last time the price of oil declined by more than 40 dollars in less than six months, there was a financial meltdown on Wall Street and we experienced the deepest recession that we have seen since the days of the Great Depression.
And now many fear that this collapse in the price of oil could trigger another financial panic.
According to Citigroup, the energy sector now accounts for 17 percent of the high yield bond market.
J.P. Morgan says that it is actually 18 percent.
In any event, the reality of the matter is that the health of these “junk bonds” is absolutely critical to our financial system. And according to Deutsche Bank, if these bonds start defaulting it could “trigger a broader high-yield market default cycle”…
Based on recent stress tests of subprime borrowers in the energy sector in the US produced by Deutsche Bank, should the price of US crude fall by a further 20pc to $60 per barrel, it could result in up to a 30pc default rate among B and CCC rated high-yield US borrowers in the industry. West Texas Intermediate crude is currently trading at multi-year lows of around $75 per barrel, down from $107 per barrel in June.
“A shock of that magnitude could be sufficient to trigger a broader high-yield market default cycle, if materialized,” warn Deutsche strategists Oleg Melentyev and Daniel Sorid in their report.
If the price of oil stays at this level or continues to go down, it is inevitable that we will start to see some of these junk bonds go bad.
In fact, one Motley Fool article recently stated that one industry analyst believes that up to 40 percent of all energy junk bonds could eventually go into default…
The junk bonds, or noninvestment-rated bonds, of energy companies are also beginning to see heavy selling as investors start to worry that drillers could one day default on these bonds. Those defaults could get so bad, according to one analyst, that up to 40% of all energy junk bonds go into default over the next few years if oil prices don’t recover.
That would be a total nightmare for Wall Street.
And of course bond defaults would only be part of the equation. As I wrote about the other day, a crash in junk bonds is almost always followed by a significant stock market correction.
In addition, plunging oil prices could end up absolutely destroying the banks that are holding enormous amounts of energy derivatives. This is something that I recently covered in this article and this article.
As you read this, there are five “too big to fail” banks that each have more than 40 trillion dollars in exposure to derivatives. Of course only a small fraction of that total exposure is made up of energy derivatives, but a small fraction of 40 trillion dollars is still a massive amount of money.
These derivatives trades are largely unregulated, and even Forbes admits that they are likely to be at the heart of the coming financial collapse…
No one understands the derivative risk positions of the Too Big To Fail Banks, JP Morgan Chase, Citigroup, Bank of America, Goldman Sachs or Morgan Stanley. There is presently no way to measure the risks involved in the leverage, quantity of collateral, or stability of counter-parties for these major institutions. To me personally they are big black holes capable of potential wrack and ruin. Without access to confidential internal data about these risky derivative positions the regulators cannot react in a timely and measured fashion to block the threat to financial stability, according to a National Bureau of Economic Research study.
So do we have any hope?
Yes, if oil prices start going back up, much of what you just read about can be averted.
Unfortunately, that does not seem likely any time soon. Even though U.S. energy companies are cutting back on capital expenditures, most of them are still actually projecting an increase in production for 2015. Here is one example from Bloomberg…
Continental, the biggest holder of drilling rights in the Bakken, last month said 2015 output will grow between 23 percent and 29 percent even after shelving plans to allocate more money to exploration.
Higher levels of production will just drive the price of oil even lower.
At this point, Morgan Stanley is saying that the price of oil could plummet as low as $43 a barrel next year.
If that happens, it would be absolutely catastrophic to the most important industry in the United States.
In turn, that would be absolutely catastrophic for the economy as a whole.
So don’t let anyone tell you that much lower oil prices are “good” for the economy.
That is just a bunch of nonsense.
Disclosure: None.
Deutsche Bank... now where have I heard that name before and how much must the bank repay and for what fines again?
Trickle down economics, when rich people are not making huge profits and or are losing money they divest themselves of the little/poor people they employ to do the actual work that normally would keep things going. Hence the economy comes to a screeching halt.
You hit on something that I've never fully understood. When the economy isn't doing well, people are afraid to spend their money, so companies don't sell products and end up cutting salaries, or laying off, or at the very least having hiring freezes. That makes people have even less money to spend which causes even fewer sales, and it becomes an endless cycle. But what can make it stop?
A keynesian (Someone who believe John Maynard Keynes view) would say thats when government (which should have been saving money in the boom time) starts spending money on large capital projects that gets people jobs and then money (and gets money moving again). Problems is it usually incurs large debts, often the jobs are temporary and don't help the ones laid off, even more so in these days of certification and training for years before you get a job.
A monetarist or a friedmanite would probably talk more in terms of loosening credit, reducing interest and making more cheap money so that people have access to capital for investment. and again helps free up the money from pools (because its not worth storing it with low interest rates you spend it).
Basically trying to get money flowing round the system (velocity of money) and various other complex economic theories. As any economist reading this will tell you I'm not one. The explanations are simplistic and slightly wrong in some ways by being so simplistic - I'm a Professional Engineer by background so I tend to look at money through that lens and try to abide by KISS principle. Any economists here can elaborate.
Problem is (I used to believe in Keynes - Hoover dam and Las vegas which grew up because of it, or Golden gate bridge - are examples) but it tends to be rubbish because governments don't possess the discipline and because it bucks the free market and is very socialist. Problem is moneterism is also not really working very well either and risking deflation.
I'm starting to try to look at Von Mises' ideas for an answer but still not really understanding.
Exactly, people need confidence in the economy so that they do spend. That's why the Obama administration is constantly trying to convince people the economy is improving in the belief that, if people have confidence that things are getting better, they will spend more, which will force companies to start hiring again, and reverse the cycle.
Unfortunately, the numbers have rarely matched what Obama has said so experts come out and negate his claims killing the reversal before it starts. Things are still bad, but I think slowly they are getting better. At least gas is now cheap so people have a bit more spending cash.
its good for the little guy hes got nothing to lose anyway
Except whatever job he/she was holding onto because the big investor didn't want to have to do it.
Even the price fall below USD 20, the dynamic of "finance" and "economic" will take us to next level. Just like QE been introduce, any changes is good for every country. Please do made yours self "usefull" and "value", that is the way of life...hahhahah
The news reports of 5 January 2015 about Euro having slumped to nine years low, could have been possibly caused by Greece elections plus falling oil prices, points to precise accuracy of this writer published on 2 June 2014 as :- " Downward trend in world economy is likely to be in mild form during
November, 2014 to April, 2015, to grow somewhat intense during May, 2015
to October, 2015, becomes harsh during November, 2015 to July, 2016.
Such areas of life as minerals and metals, foodcrops, energy resources like oil and gas , defence and security of nations are likely to bear the brunt of these trends.
Collective wisdom in decision making, communication systems, aviation industry, and the cinema, music and TV industries could be , in addition, touched by these trends.
Countries or regions whose names begin with the letters B, E, EU, N, O, P, U or V may need to implement multilevel approach to challenges during this period". The list is just an artist's view, may be applicable where appropriate."
This is the substance or salient feature of my article - " Stressful times ahead for world economy in 2015 and 2016"- published online on 2 June 2014 at Astrologyweekly.com. It may however be observed here that these predictions of likely trends are indicative and not deterministic suggesting that, in human scheme of things to happen, there is always room for reform, salvaging or improvement through a renewed but sufficient and appropriate strategy. Further, these predictions are in the nature of entertainment.
With lower oil prices, your lubricants, chemicals, synthetic fibers, pharmaceuticals, plastics
-will now be cheaper to produce.
Consumers are one of the main drivers of the economy, they will have more in their pockets and there will be more demand for all of the above. This will create, as Michael Snyder puts it, the kinds of jobs that we cannot afford to lose. Jobs at places like Boeing, Dow Chemical, Apple, Fedex, Caterpillar, John Deere, Ford, GE, Xerox, and Microsoft. You know, the little mom and pops that populate the S&P 500.
The USA is not Saudia Arabia. America uses all the oil that it produces and imports more. Oil price drops will help boost the economy for the 90% of businesses that are not oil related.
For every oil patch job lost, 10 will be created in other parts of the economy.
Geez, Mr. Snyder look out for when the price of bananas drop, the world will surely end!
Yes, nice comment. I agree completely.
Great post, thanks for sharing.