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