By W. Rocky Newman and John R. Bowblis:
Traditionally, low oil prices have been a boost to economic growth in the U.S. The crash in oil prices over the past two years, however, has produced a decidedly mixed picture – with potentially worrying implications for the economy as a whole.
When oil prices fall, consumers spend less on gasoline and have more disposable income to spend on other goods, which contributes to economic growth. Conversely, as oil prices have gone up, consumers have less disposable income to spend on other things, such as new cars, going out to eat, entertainment and new clothes.
Consider the average family who logs 15,000 miles a year and owns a vehicle that gets 20-25 miles per gallon. If prices at the pump are US$3.80 per gallon, this family would need to spend $2,280 to $2,850 per year, but if gasoline prices fall to $1.80 per gallon, then this same family would spend less than half that, saving $1,200 to $1,500 per year. This is a significant increase in disposable income, given that per capita household income in the United States is around $55,000 per year!
This savings from lower oil prices is compounded by lower prices in other goods such as milk, beer, electronics and clothing, which all cost less to produce and transport with lower energy and fuel prices.
But things are different this time. The U.S. is now the largest producer of oil in the world, which means domestic oil and gas companies – and the states they operate in – are hurt by low prices.
What is less appreciated is that continued cheap oil has the potential to wreak havoc in the financial markets. When times were better, oil companies took out bank loans and hedging contracts against big swings in oil prices, which will come due in the months and years ahead. Bad outcomes from these past financial bets could have a ripple effect far beyond oil and gas.
Oil and gas now a bigger part of our economy
The notion that cheap oil helps the economy is based on the assumption that the United States is a net importer of oil and gas. In other words, the U.S. gains from lower oil prices with very little of the losses.
Over the past 10 years, though, the oil and gas industry has changed dramatically. North Dakota now produces more oil than Alaska. Combined with the exploding growth of the natural gas industry from fracking, the U.S. is currently producing a much larger percentage of our oil consumption and we are virtually self-sufficient in our use of natural gas.
When energy prices drop, geographic areas heavily reliant on the oil and gas industry may suffer as companies stop investment and expansion, idle production and curtail jobs. And that’s exactly what’s happening: with the recent drop in oil prices, oil service companies such as Schlumberger and Halliburton have cut nearly 25 percent of their workforces.
The results of these cutbacks and layoffs are not limited to those directly working in the oil and gas industries, but also with the businesses where they buy equipment and modernize their facilities. Layoffs also impact the business where employees spend their money buying housing, cars, food and entertainment. More than 10 million jobs are now tied to the oil and gas industry in the U.S.
For American consumers, then, there’s a yin and yang effect: we are saving at the pump, but we feel the chilling effects of a hurting oil and gas industry. Despite the savings of lower energy prices, the overall effect may be a net negative as industry slows investments in drilling operations, followed by less spending on their day-to-day operations and layoffs.
The impact is uneven geographically: regions like the large populations of the East and West Coasts, which have economies that are less dependent on the oil and gas industry, will benefit from cheap oil. At the same time, regions more dependent on the oil industry, including Texas, North Dakota and Alaska, have suffered. As recently as 2014 all 50 states were creating jobs. Now oil price reductions threaten many of those new jobs in Texas, Louisiana, Wyoming and North Dakota, potentially moving those states back toward recession.
Meanwhile, oil-producing countries around the world are keeping the spigots open, creating a market glut that has driven prices from $100 per barrel in 2014 to under $30.
With oil companies suggesting their true cost of production to be near $50 per barrel, they and their suppliers are burning through cash reserves at an extremely fast rate.
Hedging helps for now
As painful as the downturn is in the oil and gas industry, the worst may be yet to come as bets placed by banks and commodity traders play out.
Both buyers and sellers of commodities utilize the futures markets in an attempt to reduce price risk. Buyers of commodities purchase future contracts – called hedging – on the open market, essentially betting that prices for what they will need to buy in the future will go up.
This is like buying car insurance. Your premium is essentially a bet that you will get in a wreck. The insurance company is betting you will not. If you do get in a wreck, your losses are covered. If you don’t, the insurance company keeps your premiums. You are out the premium in any case but happy for the peace of mind.
Buyers of futures contracts are essentially buying insurance against price increases. If prices do go up, they buy at the lower rates on the contracts. If the prices stay below the contract, they are out the premiums but are happy for the peace of mind.
In a similar way, oil companies can buy future contracts to sell (rather than buy) at a given price, essentially betting that prices will fall. For example, an oil company could buy a future contract to sell at $60 per barrel and know it will be profitable even if prices drop below that price.
Most oil companies regularly purchase these contracts a year or two at the most into the future. This means that they can still get $50-$60 per barrel for the oil they sell until those contracts run out. For now, oil and gas industry losses due to plunging prices are mitigated by the hedges.
With prices hovering around $35 per barrel, who takes the losses from these hedges? In effect, the oil companies transferred their current operating losses to those market traders who sold them the contracts, or “took the bet.”
But hedges are usually short-term in nature – no more than one to two years out – and many of the contracts are expiring. With much of the industry unhedged beyond one or two years, oil and gas companies are now likely to see significant losses. Why? The cost of production is greater than current and near-term expected prices and companies no longer have hedging contracts to shield them.
Many U.S.-based oil companies also sell natural gas, but that, too, remains very cheap and abundant, causing the same profitability challenges as the oil supply glut.
Banks getting worried
Banks, too, are vulnerable to a financial reckoning at oil and gas firms.
Like the housing boom of the early 2000s, no one thought the price of oil could fall in a sustained or significant way. With prices peaking over $100 per barrel in the spring of 2008 after the housing crisis, banks were looking for a safe industries to invest in.
In response, banks loaned hundreds of billions of dollars to oil and gas companies to invest in domestic oil infrastructure.
But things have obviously changed. If the prices stay low as expected, and the hedge contracts expire, how much exposure do the banks have to very risky oil industry debt? How will it compare with the housing bust/debacle?
Several financial institutions are already building reserves to offset the fallout. JP Morgan and Wells Fargo just set aside $2.5 billion in additional reserves in anticipation of losses on oil and gas loans.
Internationally, some suggest that low oil prices keep pressure on Russia, Iran and Venezuela and potentially force political change, but these low prices could do more harm than good when it comes to the domestic economy.
For those of us happy with lower prices at the pump, the law of unintended consequences could be huge.