ENERGY | Oil Below $30 per Barrel : Will Stock Market Crash?

ENERGY | Oil Below $30 per Barrel : Will Stock Market Crash?

By Various Sources

In recent years, the sharp increase in oil prices that began in 2001 and the three sharp declines that followed in 2008, due to the sub-prime mortgage crisis, at the end of 2014–early 2015 and at early 2016 have renewed interest in the effects of oil prices on the macro economy.

Chart Attribute: Brent Oil Crude Prices January 2014 - January 2016 / Source: Bloomberg

Chart Attribute: Brent Oil Crude Prices January 2014 - January 2016 / Source: Bloomberg 

Most recently, the price of oil has more than halved in a period of less than 5 months since September 2014. After nearly 5 years of stability, the price of a barrel of Brent crude oil in Europe fell from over $100 per barrel in September 2014, to below $30 per barrel in January 2016.


This raises important questions to be answered. Firstly, are economies still elastic to oil price movements, or have new, energy-related technologies and resources, like renewables and shale gas, completely sheltered them from shocks? Secondly, if economies are still elastic, are emerging and developed economies influenced to the same degree?

We answered these questions in a recent study (Taghizadeh-Hesary et al. 2015). In the study, we analyzed the impact of oil price fluctuations on the gross domestic product (GDP) growth rate and consumer price index (CPI) inflation in the three largest crude oil consumers: the developed economies of the United States (US) and Japan, and an emerging economy, the PRC. For the analysis, we selected a period that includes the most recent financial crisis, the subprime mortgage crisis of 2008. This allowed us to compare the impacts in the period January 2000–July 2008 with the period following the crisis, August 2008–December 2013



Perspective

In an analysis published in 2009, Tom Therramus pointed out that Black Monday fell into a broader pattern in which nearly every stock market crash and recession of the preceding 50 years had occurred shortly after a large and abrupt change in the price of oil. In the case of the 1987 Dow crash, it was foreshadowed by a tumble in oil price that ensued in the wake of disputes within OPEC, which had come to a head in the previous year.

During the mid-1980s Saudi Arabia grew increasingly frustrated with cheating on agreed oil production quotas by other members of OPEC. In 1986 the Saudis gave up honouring their own quota commitments to the cartel and the price of oil plummeted.

Current falls

Between July 2014 and January 2016, oil price went below $30 per barrelOne of the steepest legs of this decline was a 10% drop that occurred on Black Friday November 28, 2014 following a meeting of OPEC. The ostensible reason for this fall was that the Saudis had refused to agree to production decreases being pushed by some OPEC members, instead choosing to let the market play out for the time being.


What are the impacts of oil price fluctuations on emerging and developed economies?  

Empirical results show that the impacts of oil price fluctuations on GDP growth rates for developed oil importers (US and Japan) are much milder than for emerging economies like People's Republic of China (PRC) (Taghizadeh-Hesary et al. 2015). The reasons for the difference between the impacts on these two groups are high fuel substitution (higher use of nuclear electric power, gas, and renewables), a declining population (in the case of Japan), the shale gas revolution (for the US), greater strategic crude oil stocks, and government-mandated energy efficiency targets in developed economies compared to emerging economies, which make them more resistant to oil shocks. In comparison, the impact of higher crude oil prices on PRC CPI inflation is milder than in the two advanced economies. The reason for this is that the higher economic growth rate in the PRC results in a larger forward shift of aggregate supply, which prevents large increases in price levels after oil price shocks.

Chart Attribute: Annual statistical bulletin of the Organization of the Petroleum Exporting Countries (OPEC) (2014).
Chart Attribute: Annual statistical bulletin of the Organization of the Petroleum Exporting Countries (OPEC) (2014).

By comparing the results of these two subperiods—(i) January 2000–July 2008 and (ii) August 2008–December 2013—we can conclude that in the second subperiod, the impact of oil price fluctuations on the US GDP growth rate and inflation rate was milder than in the first subperiod because of the lower crude oil and aggregate demand resulting from the recession in the economy. For Japan, the second subperiod coincides with the Fukushima nuclear disaster that followed the massive earthquake and tsunami in March 2011, which raised the dependency on oil imports. Hence, the elasticity of GDP growth to oil price fluctuations rose drastically. CPI elasticity declined, however, because of diminished consumption due to uncertainty in the nation’s future after the disaster. 

The PRC’s GDP growth and inflation rate elasticities to oil price fluctuations were almost constant in both subperiods. The main reason for this is the appreciation of the yuan. Shortly after the sub-prime mortgage crisis, oil prices started to increase sharply due to a mild recovery in the global economy and the huge quantitative easing policies of the US and monetary authorities in other countries. Simultaneously, the yuan appreciated compared to other currencies, meaning that the price of crude oil in the PRC’s domestic market did not fluctuate as much. The result was that crude oil prices had almost no impact on the PRC’s economy (GDP and inflation) before and after the crisis.

Possible Scenario:

The mechanism by which a fall in the price of oil could trigger a collapse in the stock market lies in the financial devices used to fund oil exploration and exploitation throughout the world and particularly in the United States. Modern oil exploration is financed through a range of methods including issuance of shares to increase capital, and raising debt through bonds and bank loans.

shale oil well operating through hydraulic fracturing can cost $9 million to get into production. When oil was hovering close to $100 per barrel, banks were more than willing to finance billions of dollars worth of oil exploration projects. As far as banks were concerned these loans were backed by tangible assets and considered low-risk. It was (almost) like printing money. A price of $80 per barrel was seen as a floor in the profitability of shale oil. This took an average break-even price of $70 per barrel, plus a $10 margin for financing costs.

Today with oil under $30, many producers lose $20 for every barrel produced and will likely default on these loans, as outlined in last month’s “Falling Oil Price Slows US Fracking” article. This loss will be passed to the banks that made the loans, as it happened with the housing sector in 2008.

A telltale sign of this is the recent 20% fall of high yield corporate bonds since this summer that follow very closely the fall in crude oil prices. Many investors are afraid of defaults in the high-yield market due to over-lending to the energy sector and are indiscriminately selling off “junk bonds”. The downside of this corporate bond selloff across the board is that less favourable financing options will be available for other sectors, which in turn will spread the slowdown to the rest of the economy.

Simple mathematics reduces a credit-worthy company to bankruptcy — for example a company with a market capitalization of $50 million owing $9 million suddenly becomes a bad risk when its total value dives to $10 million thanks to the sudden switch from profit to loss caused by the fall in the price of oil. A loss of profitability causes a loss of share value — pension funds and investment houses have seen billions wiped off the value of their investments in a matter of a few months. The knock on effect of loss of value then permeates to the banking and insurance sectors, causing the value of stock in those companies to fall.

Not all shale oil exploitation was financed by loans and bonds. Derivatives have played a part, too and many of the main players in the fracking business have their prices set in futures contracts all the way into 2016. The holders of these obligations to buy will be in serious trouble if the oil price does not turn around by mid-2015 when many of these contracts fall due. The major Wall Street banks hold a total of $3.9 trillion worth of commodities contract, the bulk of which are based on oil and were written when oil seemed to be destined to remain above $80 per barrel. If the price of oil stays below $80, America’s biggest financial institutions will have to beg — once again — the Fed (and the taxpayer) for help.

In addition to those companies that drill for oil and those that finance them, there is a large industrial sector supplying tools, chemicals and equipment to the oil industry and the value of shares in those companies will tank as oil production winds down. Major index component companies, such as GE and Halliburton will see a loss of business and an inability to cover investments and loans in their oil industry divisions. These financial shortfalls will affect dividend payments or force them to sell otherwise profitable divisions to cover their losses. When the value of index component companies falls, all index-linked investment funds fall into losses. Managers of these funds usually sell off profitable assets to meet their obligations. A sudden shortfall of cash caused by an unexpected fall in the oil price could then trigger a sell off on Wall Street in which case the price of all shares would drop under an urgent rush to sell.

Should energy loans start to default, we may be looking at a snowballing effect in the order of the 2008 banking crisis with a caveat: low oil prices do help reduce the cost of transportation and services and may be a blessing in disguise for the economy. However this plays out, our FFT analysis illustrates that volatility is on the cards. Fasten your seatbelts for a bumpy ride, and keep an eye open for opportunities. As Warren Buffett once said: “Be fearful when others are greedy and greedy when others are fearful.”


Reporting from ADB Blog, UN University Blog and EIA Press Release  
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