Source: Financial Times
In the second half of 2015, the financial markets were driven by expected actions by the Fed. In the first half of 2016, it has been driven by oil prices. The rapid rise from sub-$30 in January to over $40 in March has buoyed financial markets. However, investors' angst over low oil prices has puzzled the IMF:
Since June 2014 oil prices have dropped about 65 percent in U.S. dollar terms (about $70) as growth has progressively slowed across a broad range of countries. Even taking into account the 20 percent dollar appreciation during this period (in nominal effective terms), the decline in oil prices in local currency has been on average over $60. This outcome has puzzled many observers including us at the Fund, who had believed that oil-price declines would be a net plus for the world economy, obviously hurting exporters but delivering more-than-offsetting gains to importers.
The popular narrative amongst the mainstream media is that low oil prices would be good for the economy. Less spending at the pump could give consumers more discretionary cash to spend on retail, travel, etc. The extra spending would be a boon for the economy. However, many Americans who are living paycheck-to-paycheck need to horde savings to stave off the next recession. Low oil prices won't help the global economy for two other reasons:
It Could Hasten Energy Bankruptcies
Through mid-December there were 41 oil and gas bankruptcies with collective debt totaling $16 billion. It could worsen if oil prices remain "lower for longer." According to the EIA, onshore oil producers' debt service as a share of operating cash flow exceeded 80% in Q2 2015.
Oil firms have feasted on cheap debt amid the energy boom that followed the financial crisis. Oil and gas debt increased from $1 trillion in 2008 to about $3 trillion in 2014 - over half was represented syndicated loans. And bankers are trying to save themselves before more firms collapse. They are reducing their revolving lines of credit before falling cash flows erode what little assets oil and gas firms have left. Banks like JPMorgan (NYSE:JPM) and Morgan Stanley (NYSE:MS) have helped firms raise $9 billion in equity so far this year; the lion's share has gone to repay revolvers the energy firms owed to banks.
A driller's collapse can trigger thousands of layoffs and cause deflationary pressures in the towns they inhabit. Their inability to repay banks hurt bank earnings and can potentially hinder banks' ability to honor counterparty claims. Such retrocessions could make energy debt the next moral hazard.
It Could Hurt Emerging Countries
Emerging countries are particularly vulnerable. Many rely on exporting commodities/metals like iron ore, oil, aluminum, etc. China is the biggest buyer of commodities and its declining imports have punished emerging countries. Cash flow from exporting oil at prices above $100 was potentially an opportunity to diversify away from oil. However, neither Venezuela nor Brazil were able to make the leap.
Fifty percent of Venezuela's exports is related to oil, and the country's prospects and China's prospects are intertwined. China's $60 billion in loans to Venezuela have given it access to the country's oil. Nonetheless, the decline in oil prices has ravaged Venezuela. In 2015, it experienced one of the world's deepest economic contractions. Its economy is expected to fall another 6% this year.
Only 10% of Brazil's exports are related to oil, but the country is in dire straits. Brazil is reeling from political upheaval. President Rousseff is under attack due to allegations of corruption by former president Luiz Inacio Lula da Silva pursuant to Petrobras (NYSE:PBR); Lula is a former mentor to Rousseff. Political turmoil will make it difficult for the government to sell a necessary austerity package to the public or to Congress.
Meanwhile, the populace is suffering. Brazil's unemployment rate is over 8% and the economy is expected to contract by nearly 3% in 2016. Its debt-to-GDP has risen from 59% in 2014 to 66% at the end of 2015; Puerto Rico's was 70% before it defaulted on its debt. About $300 billion of its sovereign debt is U.S. dollar-denominated which increases as the real depreciates against the dollar.
The desire to keep emerging markets' currencies from depreciating further was likely a reason the Fed did not raise rates earlier this month. There is about $9 trillion in U.S. dollar debt to non-U.S. borrowers, of which $4.5 trillion is to emerging countries. Declining prices for oil (and other commodities), combined with depreciating currencies, and trillions in dollar-denominated debt sounds like a calamity waiting to happen.
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