Tuesday, January 13, 2015

Impact of Low Oil Prices? - It's Complicated

The near 50% drop in oil prices is of course something everyone knows about. There is much debate going on about whether the lower prices will have a good impact, a bad impact, or a nuetral impact (lower costs for consumers offset loss of jobs and growth for producers). The reality is that this subject is very complex and we will not know all the impacts for several months because they will work through the economy over time. I say that having spent over 35 years working in the oil and gas industry (as an accountant). 

This article in Business Insider is one of the best I have seen. It is based on a more in-depth article by actuary Gail Tverberg  on her blog OurFiniteWorld.com. It delves into just how complex this subject really is. I highly recommend reading the entire article even though it offers a somewhat bleak picture of the future. The article does an excellent job of walking you through all the various potential impacts of the low oil prices. Below I will select a few key quotes and then add a followup comment.

 Business Insider: The Current Oil Crisis is more Dangerous than you Think

"The price of oil is down. How should we expect the economy to perform in 2015 and 2016?
Newspapers in the United States seem to emphasize the positive aspects of the drop in prices. I have written Ten Reasons Why High Oil Prices are a Problem. If our only problem was high oil prices, then low oil prices would seem to be a solution."
. . . . . 
"It seems to me that the situation is much more worrisome than most people would expect. Even if there are some temporary good effects, they will be more than offset by bad effects, some of which could be very bad indeed."
. . . . . 

This article goes on to provide a list of some of the possible bad effects. I will just pick out a few below that are very important to understand. But please read the whole article linked above.

1. Increased debt defaults. Increased debt defaults of many kinds can be expected, including (a) Businesses involved with oil extraction suffering from low prices (b) Laid off oil workers not able to pay their mortgages, (c) Debt repayable in US dollars from emerging markets, including Russia, Brazil, and South Africa, because with their currencies now very low relative to the US dollar, debt is difficult to repay (d) Chinese debt related to overbuilding there, and (e) Debt of failing economies, such as Greece and Venezuela.
2. Rising interest rates. With defaults rising, interest rates can be expected to rise, so that those making the loans will be compensated for the rising risk of default. In fact, this is already happening with junk-rated oil loans. Furthermore, it is possible that the US Federal Reserve will raise target interest rates in 2015. This possibility has been mentioned for several months, as part of normalizing interest rates.

. . . . .
4. Increased recession. The combination of rising interest rates and rising unemployment will almost certainly lead to recession. At first, some of the effects may be offset by the impact of lower oil prices, but eventually recessionary effects will predominate. Eventually, broken supply chains may become a problem, if companies with poor credit ratings cannot get financing they need at reasonable rates.
. . . . . 

7. Defaults on derivatives, because of sharp and long-lasting changes in oil prices, interest rates, and currency relativities. Securitized debt may also be at risk of default.

. . . . .
"In total, eventually we are likely to experience a much worse situation than we did in the 2007-2009 period, although this may not be evident at first. It will be only over a period of time, after some of the initial “dominoes fall”, that we will see what is really happening. Initially, economies of oil importing countries may appear to be doing fairly well, thanks to low oil prices. It will be later that the adverse impacts begin to take over, and eventually dominate."
My added comments:
I only picked out a few of the possible problems from low oil prices from the full list in the article. But these illustrate the potential ripple effects that can move throughout the economy that are not immediately obvious. Item #7 above is very important as we have noted here many times. There is no way we can possibly know what derivative hedges may be in trouble right now due to this huge and sharp drop in price. It can be a few months before the problems might surface.
I will use a typical oil company as an example. An oil company might decide to hedge a portion of its annual production to insure a certain minimum price. They do this by opening a hedge contract with someone like a bank. The oil company sells the oil today at a fixed price for the whole year to lock that price in. The bank needs the price to go up or it will lose money on the hedge derivative contract. The bank has to pay the agreed on price to the oil company no matter how low the market price goes. When the price collapses the bank might lose a lot of money. Some banks do some heavy speculating using these contracts beyond just hedging real production from producers.
This raises the question of whether or not the bank can stay solvent to pay its obligation to the oil company on the hedge contract. Supposedly, the bank takes the risk into consideration and finds a way to hedge its own position to limit its risk. But who really knows how well the bank has manged this process? And did the bank take into account prices falling this far this fast? Many of these contracts are not transparent so no one really knows what the true risk is. They can stay hidden for awhile.
Clearly, this is a very complex situation with many variables as this Business Insider article by Gail Tverberg points out. Only time will tell us how well all the risks have been managed and if this will impact the stability of the whole banking system or not.

Added note: Here is an interview with David Morgon in this topic that is worth the time to watch.

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