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"Austrian" Investment Themes, Commentary and Opinion, Economics

Q&A: The Collapse of Oil Prices

By Ted Barnhart

The recent plunge in oil prices, poses a number of questions.  The Austrian School of Investment Thought Blog answers a few of them here.

Q: Is the price of oil dropping because of deflationary forces i.e. an anticipated economic slowdown.

A: No, but a couple of side bar discussions should go along with that answer.

First, there is no question that the drop in prices is the result of an increase in supply.   A recent analysis from Stratfor.com posed that:

 “The amount of oil production that has come online over the last four months is staggering. The United States has increased its production from 8.5 million barrels per day (bpd) in July to an estimated 9 million bpd. Libyan oil production has increased from about 200,000 bpd to more than 900,000 bpd. Saudi Arabia, Nigeria and Iraq have all increased production in recent months, and OPEC’s production is at the highest level in two years. To put this into perspective, the International Energy Agency’s projection for global oil demand growth for 2014 is only 700,000 bpd — roughly half of the total production increase mentioned above.”

 Isaac Arnsdoff writing on Bloomberg.com however, noted that such market dynamics were well known when prices started “easing” from a peak of $107 at the end of June. The real question is come October, Why did prices go down so far so fast?  According to Arnsdoff’s article the tipping point was a price cut by the Saudi’s on October 1st, which signaled to markets that they were going to defend market share at the expense of prices.

oil rigWhile the drop in oil prices is not the result of deflationary forces, a continued decline could unleash some deflationary forces. First would be an expected drop in producer as well as consumer prices In addition, break even prices for U.S. shale based production the are estimated from $60 to $70 per barrel. A prolonged price below these levels could spur distress in debt issued to finance such production, as well as a slowing or drop in domestic oil industry employment.

It should also be noted that activity in other commodity prices may be signaling a potential economic slowdown.   Copper and Silver futures are both down more than 10% in the last year. More ominously, according to Zero Hedge.com  is recent activity in the Baltic Dry Index , a highly watched indicator of supply and demand for shipping of commodities related to industrial production.

 

Q: Why would Saudi Arabia want Lower Oil Prices?

A: It is hard to say for sure, but it could be as simple as a desire to put pressure on the competition. Specifically, North American shale production poses a long-term threat to the Saudi position as King of  Oil Production and U.S. dependence.

There is also some thought that perhaps the Saudi’s are taking the opportunity to put pressure on Iran saudia arabiawhose growing influence in the Middle East poses a threat. It is not hard to notice that the Saudi price cut comes at the same time that negotiations over the Iranian nuclear program, have yielded little results, with yet another extension of a deadline to produce a deal.

Such a strategy could also be a aimed at the Russians, in retaliation for interference in Syria, and/or as a deal with western countries to combat Russia’s strong arm moves in the Ukraine.

 

Q: If lower oil prices are good for the economy why did the stock market take a nose dive earlier this week on oil concerns.

A: Personally, I think the drop in market this week was driven by a Chinese move to tighten loan rules and renewed fears of a Greek exit from the Euro. Sure there is pressure on the Energy sector which makes up more than 9% of the S&P 500, but the link of falling oil prices to falling stocks this week was probably overblown.

 

Q: Will the oil price collapse trigger a new financial crisis.

A: Never say never, but it is extremely unlikely. A growing number of articles and pundit discussions suggest that the price of oil could spark a financial crisis. It is true that a the North American shale boom has been financed with high yield debt that is coming under increasing pressure as production costs exceed market price. A prolonged period of low prices will cause hardship and default in these energy sectors as well as banks that have significant exposure either directly or indirectly. Such an outcome would in all likelihood be restricted to the regions and industries affected not unlike the regional effects suffered in the Texas bust of the mid 80’s.

It is understandable that such words are not comforting to those who remember Fed and Treasury officials insisting that the sub-prime debt crisis would not spread to the economy as a whole back in 2007, but there are a couple of key differences:

1) Total mortgage debt heading into 2008 was roughly $12 trillion (about $ 2 trillion being sub-prime originations leading up to the crisis), while the outstanding energy debt issued to finance shale production is estimated to be just $500 billion.

2) While it was not widely reported at the time, there were very clear danger signs indicating that the financial industry was on the verge of default. Credit default obligations (CDOs) for major wall street firms and banks were trading at levels indicating “junk” status long before such distress hit the stock prices themselves.   In addition given how much leverage the financial companies utilized, it was easy to see that just a modest impairment of assets (loans) on the balance sheets would completely wipeout the equity of such firms. Those who were following such indicators not only were not surprised by the financial crisis of 2008, they were waiting for it.

Currently while High Yield bond indexes with exposure to oil production have sold off , there is no comparison in the magnitude and exposure of U.S. shale based debt to that of the housing bubble.

 Click to request an introductory phone call with Barnhart Investment Advisory

DISCLAIMER: Nothing in this article should be construed as a personal recommendation or investment advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any particular investment security. Investors should conduct their own due diligence and seek the advice of a financial and/or investment professional before making any investment decisions.

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