Friday, November 28, 2014

Dropping Oil Prices Increase Risk To Economy

The decision by OPEC members Thursday to keep their production ceiling unchanged has sent crude prices into a tailspin. The Organization of the Petroleum Exporting Countries decided not to cut oil production quota to help boost oil prices. Dropping oil prices add a surprising new dimension to the world financial system by directly injecting massive instability. While often heralded as a godsend to the economy and the end consumer we must remember lower prices hurt both producers and those in the business of oil exploration, drilling, and sales. The shale boom has been one of the bright spots in the economy in recent years and acted as a tailwind that accounted for much of America's growth. Expect this to come to an abrupt halt and with it thousands of jobs.

With the price of oil and oil futures trading hitting levels not seen in over four years, the issue of investing in new resource expansion is in flux.  In most areas of the world the price of producing oil and bringing it to market is $70 or more. This makes many plans to expand unprofitable. The oil and energy sector makes up a large and important part of the economy and many big players have made huge bets on higher prices in the coming years, often these bets are leveraged. This means we may see a collapse of some firms and investors as well as contagion which could spread like wildfire if things continue to deteriorate.

Oil prices have lost around 35% of their value since June and OPEC's decision to maintain its current production ceiling of 30 million barrels a day will not help to remove the glut that is keeping oil prices low. Nymex West Texas Intermediate crude has fallen below the $70 level and was trading at its lowest since May 2010, and Brent crude, the global oil benchmark, was at its lowest since August 24, 2010. On the New York Mercantile Exchange, light, sweet crude futures for delivery in January fell to $69.08 a barrel, down $4.61 in the Globex electronic session. How long it take to bring oil prices back up will depend on economic growth and is hard to predict.

The Drop In Oil Prices Will Impact Countries Differently
How these lower prices effect a particular nation will vary and will effect both their currency and how competitive they will be going forward. Low oil prices are a big positive for most of Asia in particular. With the U.S. becoming more self-sufficient in production and Europe’s oil demand falling, Asia is the largest remaining importer of oil in the world. With China the world’s second-largest consumer of oil seeing at least another year of low oil prices will give Beijing more leeway to loosen monetary policy.

Other major oil importers in Asia like India and Indonesia will also get a major boost because this should cause their current account deficit to narrow and the subsidy bills footed by local governments to shrink. For Japan oil prices are a positive, but much of the impact has been blunted by a weaker currency. Countries like Australia in which the government relies on rising energy exports and massive investments in oil-and-gas projects to cushion the blow of a sharp decline in minerals spending and prices will be hurt. Its booming liquefied natural gas sector sells vast quantities of the fuel at oil-linked prices.

While certain parts of the economy like transport services and airlines as well as some industries will benefit from lower oil prices dropping oil prices do cause some concern. When financial problems occur in the energy sector it is often accompanied by political instability and sometimes her ugly sister war. As a rule the economy loves stability, bottom-line dropping oil prices means more risk for an already shaky world economy. All this is being complicated by the recently strong dollar.  The dollars strength and the rising American stock market could also be taken as a sign of an unstable global economy. The money flowing in from other countries in search of a safe home screams of a bigger problem! When a strong shift in currencies occurs someone usually gets hurt and this can lead to bankruptcy, default, or contagion.  

A great deal of the shadow banking world overlaps and falls into the grey world of derivatives. A world that is both difficult to regulate and at times even harder to understand. To say derivatives are complicated is often an understatement, even the problem of defining what constitutes a derivative plays havoc with what and when reporting rules apply. The total derivatives market has grown to a massive size. It includes hundreds of trillions of dollars in over-the-counter non-reported agreements and private contracts and is estimated to be over 20 times larger than the global economy. Everyone paying attention knows that even a slight problem in a market this size could collapse the whole economic system.

 Footnote;  As always comments are welcome and encouraged. This article goes hand in hand with the article below that focuses on why currency trading may get crazy and what it means.


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  2. Bruce,

    Would you say that the World economy would be more affected than the United States economy due to low oil prices. I mean it seems as though if the United States would feel an effect it might be a secondary backlash of a country that has directly been affected by low oil prices.

    1. Josh, In my opinion some countries will be hurt very badly, and this will strengthen the dollar as money flows into America as a safe haven. We are all tied together through our banking connections so a big concern is the increased stress this will put on those deep in debt.

  3. Read Doug Nolan at the Prudent Bear and see how most of this article by Bruce Wilds is dead wrong.

  4. Rick, I did a quick read of the post by Doug Noland and while he took a different spin on the effect of lower oil prices I do not feel he proved me dead wrong or would disagree with my take. In fact we seem to agree on a great deal. The first part of his article focuses on how lower prices are hammering some countries, mostly emerging markets. Noland states "Initial stress at the Periphery only tends to spur financial flows to the Core. Serious unfolding issues can go so far as to rejuvenate Core Bubble Dynamics." Reading father he then paints the case that as the problem feeds on itself it creates a loop that will make it harder to service their debt, especially if it is in dollars, I agree.

    His article also states "King dollar placed further downside pressure on crude and commodities markets." he continues in agreement with me "but at the same time resulting dollar strength has pushed the unfolding EM collapse to the breaking point. This new dynamic provides a real policy quandary. Throwing more liquidity at the problem isn’t going to help." Again I agree, and in this post ( I delve into how this is destabilizing the world economy. I have reviewed both articles and I'm baffled as to your comment or how you interpreted what you read, nowhere should you have picked up the notion that I see an unstable economy as bullish!