Between mid-2014 and the beginning of 2016 oil went from 105 USD per barrel to barely 30 USD. This dramatic fall provoked a lot of turmoil and even panic selloffs on the markets as concerns regarding the global growth started to spark due to the fact that oil supply could not reach sufficient demand. In this article I am going to try to explain this dramatic evolution and the extremely counterintuitive point regarding the fact that low oil prices might not be as good as expected for the global economy. At least on the short run…
According to the common sense, in the Western economies, based on private consumption, cheap oil is supposed to be a highly positive sign for the economy. Households are supposed to have more means for their private consumption and thus stimulate the demand. Furthermore, companies are assumed to have lower costs as their input expenses decrease. Unfortunately, this is what was supposed to happen on the mid-term and until now we still fail to see the positive spillovers of cheap oil. In fact, we actually see the opposite.
Multinational corporations used to rely on developing countries, as growth drivers of their sales. However most of the developing countries were extremely dependent on oil exports and thus, on oil prices. The fact that these countries lost a substantial part of their revenue leads to higher income taxes for their population. Therefore, the consumption will be highly impacted and thus, this source of growth seems to be halted for the moment. On the other hand, Western markets do not seem having profited enough of lower oil prices to increase their consumption and becoming growth drivers for large corporations.
Furthermore, the oil boom in the United States seems to be halted as well. Recent American oil extraction techniques are only profitable at significantly higher oil prices in the range of 70 to 80 USD per barrel. Some oil companies are even less cost efficient and require higher process to operate. When fracking techniques began to expand in the United States, many small oil companies started to develop themselves, which brought an important amount of new investments and working places. Oil companies attracted employees from all over the United States by offering them wages that were above the market averages. Unfortunately, today American oil industry is in a cost saving perspective and turned to a survival mode. Investments, tax revenue and employment will be strongly impacted by the fall in oil prices.
What is perhaps a little bit less intuitive is that there is also a huge exposure on behalf of banks to lower oil prices. Oil industry requires massive fixed costs and continuous investments. Therefore the industry operates with a relatively high level of leverage. Leverage is not an issue when oil prices are high and when even badly operated oil companies are profitable. However it becomes a serious issue when oil prices go down, especially if markets are in a fast and continuous downtrend.
When oil prices fall, companies try to hedge their business operations with derivatives such as futures, forwards and swaps. However, as time goes by, companies have steadily less tools to remain profitable, as hedging becomes more expensive. Without sufficient operating profit, companies still need funds in order to repay their interests on debt. Therefore, even if companies must sell at a price that is below their operating costs, they are still obliged to continue the output. Companies would face an even bigger loss than the loss that they would have from selling bellow their costs, due to important fixed costs and leverage. Selling at a loss is a necessity to extend their life expectancy and not to fill immediately for a bankruptcy. In such cases we clearly see the importance of an efficient cost management during the favorable business periods, which allows making a moat in case if things go bad. Unfortunately, with the majority of analysts shouting that there is no ceiling in oil prices and they can only go higher, there were very few incentives to spare for the future.
So where do the banks stand in this gloomy picture?
Banks operate as underwriters and loaners. As mentioned before, oil companies required additional funds to take advantage of the oil boom and stay in the race against their competitors. Therefore, banks played a major role in the liquidity provision. As oil was still in the range of 100 USD per barrel, lending to oil companies seemed as the safest operation for banks. Unfortunately, today banks are stuck with these credits and even worth, they contractually committed to additional extensive credit lines to oil companies.
There is a tradeoff for banks between going on lending even more funds, hoping that oil prices would recover in the near future, or letting oil companies down at this stage and being almost sure that they would go bankrupt. By cutting the funding, banks will be quiet sure that they will never recover all the funds that they lent. On the other hand, banks might limit their losses in case if there is absolutely no hope for a recovery on a short run.
Meanwhile, banks increase their provision to the loss of credits and provisions amount to hundreds of millions, depending on the bank’s exposure. Since 2015, 42 oil companies filled for bankruptcy. To put things into a perspective, as of today, Citigroup has a $58 billion oil and gas exposure, Bank Of America $43.8 billion, JP Morgan and Chase $42 billion and Wells Fargo $42 billion (including committed credit lines). Therefore, low oil prices seem to signal a serious threat of a huge financial distress not only for the oil industry, but also for the whole banking and financial sector.
So where are we heading right now?
Analysts are quiet mixed regarding the future evolution of the oil prices. Some argue that the worst is over and that we reached the bottom. Others think that the worst is still to come and that we might even go as low as 10 USD per barrel before markets would finally realize that they went too far. Considering the fact that most of the American oil industry is not profitable at these price levels, we can easily assume that there are going to be a lot of mergers, takeovers and bankruptcies in the very near future. On the other hand, the recent agreements between Saudi Arabia and Russia to curb the output seem too fragile from the historical and political perspectives, especially in the wake of the Iranian refusal to cooperate with the OPEC.
It is also important to emphasize that since the beginning of the downtrend of the oil prices, oil suddenly started to be considered as an accurate proxy for worldwide economic growth and, thus, financial markets started to be highly correlated to oil prices. When oil prices went higher, markets went higher and vice versa. Numerous analysts argued that if oil reserves grew and if the supply was not reaching demand, the issue came from the demand side and thus, from a coming recession. However, in reality, oil demand actually rose by 3.1 million barrels a day in two years till the end of 2015, while supply rose even faster by 5 millions a day during the same period. Obviously, in this configuration, this decrease in oil prices does not reflect a lagging behind worldwide economy, but instead, simply reflects the technological breakthrough that has been realized in the output.
Finally it is also worth mentioning that oil still remains our main source of energy. No one actually knows when a sustainable and cost efficient alternative source of energy would be discovered or developed. Therefore, for the near foreseeable future worldwide economies will still highly rely on oil. For the moment, there are no reasons to think that oil should be valued that low and that something fundamentally changed. Furthermore, despite the fact that a lot of analysts think that the development of alternative green energies will not be impacted by their immediate substitute, oil, it is still worth considering that with such low-priced oil, there are no real incentives to migrate towards less cost efficient alternatives. The financial argument of developing alternative sources of energy is currently at a standby, whereas the financial point of view is perhaps the main driver of green funding. Nevertheless, hope still remains that the savings that will be realized through lower energy costs will not be wasted but instead, will be reinvested in cleaner energies.