Akash Prakash: Oil at $60 isn't all positive
The global implications of falling oil prices are largely positive - but that doesn't mean that there aren't some risks, too
Akash Prakash
December 11, 2014 Last Updated at 21:50 IST
Everyone is busy celebrating collapsing oil prices, and the huge positives this will bring to the global economy. From mid-June, prices are down by more than 40 per cent, with Brent now falling to below $65 a barrel. There are many highly credible commentators calling for a continued price spiral, with price forecasts of $50-55 a barrel by mid-2015 not uncommon. Where prices ultimately settle and for how long is obviously anyone's guess, but this is a huge move with global implications both politically and economically.
Is such a large move in so short a time unambiguously positive for the global economy, as almost everyone seems to believe? Is it a massive tax cut and more or less a free lunch as most want to believe?
The decline in oil prices is simply a transfer of purchasing power from the producer of oil to its consumer. From theglobal economy perspective, there is no additional wealth created.
The obvious positive is that this transfer of wealth from the oil producers to the consumers/importers should lead to a boost in consumption. A $40-a-barrel decline in prices will lead to a transfer of $1.3 trillion a year. It is widely accepted that this will lead to a boost in global gross domestic product (GDP), as the propensity of the oil importer to consume is greater than the propensity of the oil producer to spend.
Markets also cheer as the importers are the European Union, Japan, China, India and even the United States, all far more relevant for global financial markets than Russia, Venezuela, Iran or Nigeria (the worst hit by the decline in prices). While this is a short-term positive for global growth, as consumers spend and consumption accelerates it will imply a decline in global savings, which may have longer-term consequences on financial markets and interest rates. Ultimately, the oil producers were not just sitting on their oil revenues, they were invested in some financial asset, somewhere in the world. This investment will stop as consumption picks up.
There are other implications on global financial markets, not all of which are positive. As the folks at Gavekal point out, nobody seems to be thinking of the inventory and liquidity effects of such a steep decline in oil prices. Assume the world consumes about 92 million barrels of oil daily and carries about 100 days of inventory. When oil was trading at $100, $920 billion was stuck in inventories, held by someone in the system and financed by someone else. If the price of oil settles at $60, the financing needs will drop to $552 billion. Almost $400 billion of liquidity will get released into the global system. This is a positive and will only add to the excess liquidity sloshing around global financial markets. Such a capital release can fundamentally alter the economics of many players in the value chain.
However, somebody will also have to take the near $400-billion loss on existing inventories as prices for all end products adjust immediately. Some of the inventories will be held in sovereign strategic reserves, and these losses will be absorbed or camouflaged in national accounts. However, there will be collateral damage to the whole petroleum value chain, and somebody will be on the hook for these inventory losses. It is not clear where the losses will surface, and the absorptive capacity of the losers. One cannot rule out some nasty surprises. During the last big decline in oil prices, starting in 1985, large parts of the Texas banking system went under, and it was also arguably a catalyst for the eventual demise of the Soviet Union. Losses of $400 billion can stress any financial system or counterparty.
Over the past few years, we have seen a massive build-out of non-Organization of the Petroleum Exporting Countries oil production capacity, largely in shale and tar sands in North America. Many of these assets are unviable below $60-65 a barrel, and the question then becomes: how was this rapid production build-out financed? Clearly, the producers were not generating sufficient cash flow to self- finance the production/drilling surge. It was debt - either high-yield bonds or bank lending - that has financed the majority of the infrastructure needed to sustain the production surge we have seen in North America over the past five years. But at $60 oil, much of this debt can no longer be serviced.
This has already thrown the high-yield market into a bit of a tizzy, as energy was the highest share of the market and spreads for energy issuers have surged. Most players in the sector have no ability to access new high-yield issuance. If losses are significant, it may impact access to high-yield debt for all sectors of the economy. At a minimum high-yield spreads will rise. Either way, either access or cost of debt will be negatively impacted for many sectors of the global economy that need capital the most.
If banks are left holding the can, the problems may be even bigger. The losses incurred by the banks on this lending could erode their capital base and earnings power, further weakening their ability and willingness to lend. If banks do not want to lend, that has obvious implications for the pace and sustainability of any economic upturn.
The other obvious negative of declining oil prices is the impact it has on the relative attractiveness of alternative energy and renewables. It will make the world economy more carbon-intensive and less energy-efficient. Just when solar was nearly at grid parity, the bar has moved downwards.
In a world fighting deflation, lower oil prices do not really help the central banks. By putting downward pressure on headline inflation, already low inflation expectations may get further entrenched or blindside the central banks to any pick-up in underlying inflationary pressures.
Don't get me wrong, one would prefer falling oil prices to $110 a barrel any day. The decline has given India the breathing room we need to get our fiscal house in order, as we have smartly taken off subsidies and also raised taxes. The simple point is that there is no free lunch, and one should not ignore the negative repercussions of such a sharp and quick move in a critical global commodity. There will be both losers and gainers, and it is important to think this through and not be caught with the losers.
Is such a large move in so short a time unambiguously positive for the global economy, as almost everyone seems to believe? Is it a massive tax cut and more or less a free lunch as most want to believe?
The decline in oil prices is simply a transfer of purchasing power from the producer of oil to its consumer. From theglobal economy perspective, there is no additional wealth created.
The obvious positive is that this transfer of wealth from the oil producers to the consumers/importers should lead to a boost in consumption. A $40-a-barrel decline in prices will lead to a transfer of $1.3 trillion a year. It is widely accepted that this will lead to a boost in global gross domestic product (GDP), as the propensity of the oil importer to consume is greater than the propensity of the oil producer to spend.
Markets also cheer as the importers are the European Union, Japan, China, India and even the United States, all far more relevant for global financial markets than Russia, Venezuela, Iran or Nigeria (the worst hit by the decline in prices). While this is a short-term positive for global growth, as consumers spend and consumption accelerates it will imply a decline in global savings, which may have longer-term consequences on financial markets and interest rates. Ultimately, the oil producers were not just sitting on their oil revenues, they were invested in some financial asset, somewhere in the world. This investment will stop as consumption picks up.
There are other implications on global financial markets, not all of which are positive. As the folks at Gavekal point out, nobody seems to be thinking of the inventory and liquidity effects of such a steep decline in oil prices. Assume the world consumes about 92 million barrels of oil daily and carries about 100 days of inventory. When oil was trading at $100, $920 billion was stuck in inventories, held by someone in the system and financed by someone else. If the price of oil settles at $60, the financing needs will drop to $552 billion. Almost $400 billion of liquidity will get released into the global system. This is a positive and will only add to the excess liquidity sloshing around global financial markets. Such a capital release can fundamentally alter the economics of many players in the value chain.
However, somebody will also have to take the near $400-billion loss on existing inventories as prices for all end products adjust immediately. Some of the inventories will be held in sovereign strategic reserves, and these losses will be absorbed or camouflaged in national accounts. However, there will be collateral damage to the whole petroleum value chain, and somebody will be on the hook for these inventory losses. It is not clear where the losses will surface, and the absorptive capacity of the losers. One cannot rule out some nasty surprises. During the last big decline in oil prices, starting in 1985, large parts of the Texas banking system went under, and it was also arguably a catalyst for the eventual demise of the Soviet Union. Losses of $400 billion can stress any financial system or counterparty.
Over the past few years, we have seen a massive build-out of non-Organization of the Petroleum Exporting Countries oil production capacity, largely in shale and tar sands in North America. Many of these assets are unviable below $60-65 a barrel, and the question then becomes: how was this rapid production build-out financed? Clearly, the producers were not generating sufficient cash flow to self- finance the production/drilling surge. It was debt - either high-yield bonds or bank lending - that has financed the majority of the infrastructure needed to sustain the production surge we have seen in North America over the past five years. But at $60 oil, much of this debt can no longer be serviced.
This has already thrown the high-yield market into a bit of a tizzy, as energy was the highest share of the market and spreads for energy issuers have surged. Most players in the sector have no ability to access new high-yield issuance. If losses are significant, it may impact access to high-yield debt for all sectors of the economy. At a minimum high-yield spreads will rise. Either way, either access or cost of debt will be negatively impacted for many sectors of the global economy that need capital the most.
If banks are left holding the can, the problems may be even bigger. The losses incurred by the banks on this lending could erode their capital base and earnings power, further weakening their ability and willingness to lend. If banks do not want to lend, that has obvious implications for the pace and sustainability of any economic upturn.
The other obvious negative of declining oil prices is the impact it has on the relative attractiveness of alternative energy and renewables. It will make the world economy more carbon-intensive and less energy-efficient. Just when solar was nearly at grid parity, the bar has moved downwards.
In a world fighting deflation, lower oil prices do not really help the central banks. By putting downward pressure on headline inflation, already low inflation expectations may get further entrenched or blindside the central banks to any pick-up in underlying inflationary pressures.
Don't get me wrong, one would prefer falling oil prices to $110 a barrel any day. The decline has given India the breathing room we need to get our fiscal house in order, as we have smartly taken off subsidies and also raised taxes. The simple point is that there is no free lunch, and one should not ignore the negative repercussions of such a sharp and quick move in a critical global commodity. There will be both losers and gainers, and it is important to think this through and not be caught with the losers.
The writer is at Amansa Capital. These views are his own
http://www.business-standard.com/article/opinion/akash-prakash-oil-at-60-isn-t-all-positive-114121101355_1.html
