How Plunging Oil Prices Could Create Economic Upheaval

How Plunging Oil Prices Could Create Economic Upheaval


Because filling stations are just about the only businesses that prominently display daily fluctuations in prices on big billboards outside their stores, there’s a psychological by-product to the rise and fall of the price of gas. We watch the neighborhood gas station out our car windows like we do a stock ticker, and we assume that falling prices translate to much better economic times ahead, at least in terms of our personal budgets. Drops in gas prices of even a penny can improve consumer confidence, and indeed, that indicator is currently at its highest level in almost eight years

But as the United States has shifted from being overwhelmingly a consumer of oil to increasingly a producer, the collapse in the price of oil, now below $50 a barrel, will have unpredictable side effects for large and diverse sectors of the economy. This includes not just the oil and gas industry, but also finance, manufacturing and more. Ultimately, this could lead to a positive lesson about reducing volatility by bolstering renewable resources, rather than finite commodities with too heavy a footprint in the economy. 

Related: Can the U.S. Boom While the World Busts? 

Economy-watchers generally believe that lower gas prices will benefit the U.S. overall, because savings on gas can be recommitted to other consumer spending. A recent poll of leading economists reflected this view, with 82 percent expecting higher gross domestic product from lower gas prices, and literally no one disagreeing — a handful of the economists surveyed were merely uncertain. 

Of course, these same economists never saw the fall in oil prices coming. Until three days ago, Goldman Sachs still forecast future prices at $80 a barrel; they slashed that prediction to $42 all at once. Experts now expect declines below $40. Oversupply (partially due to increased U.S. shale production), but also depressed demand from an uncertain global economic picture, can be blamed for the crash. 

Normally, when prices fall, producers cut back drilling operations, either to move supply and demand back into equilibrium, or because the drilling becomes costlier than the prices you can fetch for the product (the so-called “breakeven point”). But though rig counts have fallen precipitously in recent months — last week’s drop was the largest since 1991 — crude production is actually at record levels

Related: Why Oil Prices Are Headed Below $35 a Barrel 

Part of this is increased efficiency at existing wells. But there’s also an endless production race to keep ahead of a gusher of borrowing. U.S. oil producers have around $200 billion in total debt on their books as of 2014. They can’t stop drilling and await higher prices; they have to service the debt, even if it means producing at a loss. Global production also hasn’t ceased, for a variety of reasons (an export agreement in Iraq, insistence from Saudi Arabia and the rest of OPEC that they will not shut off the spigots). This surge of supply into an already over-supplied market will just cause further price plummets, prolong the slump and exacerbate the pain. 

In the U.S., companies have to keep running up debt to preserve their cash flow. But at some point, the lending will stop, given the low revenue returns and higher repayment risk. That’s particularly true when locked-in sale prices expire, sometime in the spring, freeing traders from buying oil at elevated rates. Many oil producers also have credit lines due for renewal in March, and after this all shakes out, you can expect a wave of defaults and consolidations. 

This will create a number of upheavals. First of all, rig counts will surely drop further as the year goes on, causing a loss of good-paying jobs. Energy sector job growth has far outperformed its counterparts and contributed $300 billion to $400 billion a year to the U.S. economy this decade, so it will have a disproportionate impact. The slowdown will also hit expectations for future rig construction: U.S. Steel recently laid off 700 workers at steel tube plants in the Midwest for this reason. Areas with less diversified economies, from North Dakota to Texas, will see their states slump, affecting practically all sectors. (In Canada, for example, home sales are falling sharply because of oil price worries). 

Related: Collapsing Oil Prices Could Really Mess with Texas 

Lending to energy companies has actually been quite a cash cow for large global banks, and defaults and loss of business will weigh heavily on their fiscal outlook. Twenty percent of the Royal Bank of Canada’s investment banking book is in energy loans, for example; for Wells Fargo it’s around 15 percent. The longer the slump, the more corrosion in those loan books. And that doesn’t count bank exposure to emerging markets with oil resources, including Russia

In addition, leveraged loans — bonds made up of low-grade corporate debt — have skyrocketed in recent years, and lots of those loans were made to energy companies. There’s reason to suspect, in fact, that energy debt makes up a large portion of the recent-vintage junk bond market

Investors have already run screaming from these bonds, raising the prospect of a fire sale. These leveraged loans, by the way, represent the biggest source of Wall Street investment banking revenues, with exposures concentrated at the biggest banks. If the whole leveraged loan sector fails, then below-investment-grade companies even outside of the energy space will lose their main source of funding. 

How does this impact the real economy? First of all, support industries for oil and gas, from manufacturing to banking, will suffer from the collapse. Goldman Sachs predicts that $2 trillion in future investments will be foregone because of the crash. That can only hurt workers. Second, the elevated stress on bank balance sheets, and the potential inability for companies to finance operations, can lead to the type of credit crunch we saw in 2008. Third, there’s the disproportionate impact to states with lots of oil and gas activity

Finally, although oil does not account for every twist and turn in the market, that psychological perception — those prices up on gas stations at every corner — may be roiling the stock market. In addition to expected declines in business spending, the uncertainty over when prices will rebound and who will be affected results in increased volatility.[YR1]  A sharp drop in retail spending in December, while only one data point, suggests that the hit to wages from the loss of good-paying energy jobs may offset, at least in part,[YR2]  the freed-up money from lower gas prices (which may just be shifted into other spending, and not cause a net increase). Even if markets are freaking out unnecessarily at random bits of data, those animal spirits can eventually reach the consumer as well, and they pull back. 

Related: As Gas Prices Drop, Gas Taxes Will Likely Rise 

The larger issue is that we haven’t prepared our economy for any trouble with the fossil fuel sector. Given our warming planet, we should actually want the oil industry to shrink, but it’s too tied to the broader economy right now. New technologies make it so we can actually move beyond this problem of over-reliance. The solar industry employs 86 percent more workers in the U.S. than it did in 2010. Wind power could outpace all the recoverable oil and gas in the Atlantic Ocean in 13 years, and would never run out to boot. And wind and sun spills don’t desecrate the environment and lead to costly clean-ups. 

In a way, the oil turmoil sends a powerful signal to the world about the desperate need to divest. We can continue to scramble amid energy shocks and suffer boom-and-bust cycles forever, or we can adapt the economy to discourage risky speculation and encourage sustainability. As much as renewables represent an environmental imperative, it’s critical to the smooth functioning of our economy as well. 

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