Falling Oil: Blessing or Curse?

December 22, 2014

2014's lasting image will be that of a kitchen sink. Because this year saw investors having to contend with everything but that. The year's list of market-roiling potential problems reads like a Chinese buffet menu. A little of everything.
Ebola virus contagion. ISIS...because Al Qaeda was too soft. QE's conclusion. The Fed funds rate dilemma. Japan's ongoing recession. Syria's civil war. China's economic slowdown. Iranian nuclear ambitions. European economic woes. Russia's Ukrainian invasion. Domestic social unrest.
The list reads like a who's who of geopolitical despair.
Yet, in the words of Donald Rumsfeld, it's never the known known that gets you. It's the unknown known. Err, anyways.
Last summer, everyone in the nation was bemoaning the cost of retail gasoline. At four dollars per gallon, it was the bane of every salesman's existence. An albatross around the neck of transportation and logistics companies. A detriment to anyone planning a day trip.
Careful what you wish for.
Today, a gallon of gas costs the average American $2.34 per gallon. The last time we consistently had such low prices at the pump? 2005. And yet, many analysts and pundits have stated that these low prices aren't a Christmas gift or a tax cut, but the next shoe to drop. Global cataclysm writ large.
This has become the year's defining economic event. In a year that has redefined itself more often than Madonna. Accordingly, investors have been given another reason to panic. So sending the S&P 500 4.8 percent lower two weeks ago. Scaring investors out of the market. Just in time for the market's rebound.
What does $60 oil, and all of its subtexts, really mean? First, some historic perspective.
After WWII, copious amounts of oil flowed from the Middle East. This kept prices low, even amid the postwar industrial boom. In 1973, Saudi Arabia and other regional oil producers nationalized their oil industries and formed a cartel (OPEC). This constrained production enough to quadruple oil prices to $12 per barrel.
Since then, OPEC's willingness to stabilize fluctuating oil prices has vacillated. Prices skyrocketed after the Iranian Revolution. Then fell in the '80s as new discoveries came online in Alaska, Mexico and the North Sea. Which led to China's reemergence in the 2000s. And surging energy demand from the world's most populous nation, as well as other emerging markets, sent prices higher. Going from $20 in the late '90s to $120 a barrel in 2008. Whereby prices crashed, as the world braced for the credit crisis and ensuing global recession. Only to percolate higher as China regained its footing.
Soon thereafter, the North American shale gas and oil revolution began. Slowly at first. Then gaining speed as the global economy returned to normalcy. The boom stabilized for a few years, as domestic and foreign production met rising global demand. Then, bam. Domestic shale production accelerated. Right as Libyan oil production rose brusquely from depressed levels. As Saudi Arabia hesitated in reducing output in order to stabilize the market, falling prices fell faster. Leading to today. And $60 a barrel oil.
Today's lower pricing will likely spur consumption and keep supply growth constrained. Likely helping to sustain a short-run price of $60 a barrel. That is, if fear, uncertainty and doubt don't creep in and disrupt a fragile equilibrium. We cannot forecast OPEC's future policy. Nor the impact of easing sanctions on Iran. Nor Russia's response to a worsening economy.
In the past, the Saudis have lowered production. Supported the market. But not this time. Likely because they have an endgame in mind. Remove the weaker U.S. shale producers. Hurt ISIS by lowering the oil revenues. Hamper Iran's ability to reignite its economy as sanctions are lessened. Disrupt the economic stability of non-OPEC member Russia. And enable China, which has become the Kingdom's largest consumer, the ability to grow its energy reserves at markedly lower prices.
All of which could backfire on the Saudis tomorrow. As the Middle East is little more than a house of cards to begin with. Even as some OPEC members bemoan the loss of mother's milk derived from oil prices, the Saudis appear resolute. Does the House of Saud intend to break up OPEC? Just when you thought the Middle East could get no more Darwinian...
Given the myriad of factors at work, market pressure could push oil prices higher or lower. Yet, most analysts we respect believe that $60 oil represents a reasonable 2015 projection. Which would provide considerable consumer stimulus, at home and abroad. Assisting with consumer spending. Enhanced employment growth. And likely, rising interest rates next year.
Unfortunately, not all the news is good.
The fracking industry has been a huge source of domestic employment. Anticipated to become only more so in the years ahead. Scaling back production can only lead to slowing industry expansion. Which means less 2015 jobs growth. And possibly a rash of bankruptcies among those smaller producers. Many of whom helped to catalyze the fracking revolution in the first place.
Domestically, oil production remains a small part of the economy. Accordingly, positive consumer stimulus from lower prices will likely trump the industry's 2015 impact on GDP and employment.
The real problems lay abroad.
Consider Russia. Where oil revenues account for a majority of budget necessities and foreign exchange reserves. The loss of revenues inserts a big problem in an already dicey situation. The ruble has been crushed. Financial hardship in Russia will likely explode in 2015. Likewise in Iraq. Iran. Libya. Nigeria and Venezuela. In 1998, crashing emerging markets led to the demise of hedge fund titan Long-Term Capital Management and its coterie of Nobel Prize winning economists. The Fed stepped in to prevent a global meltdown.
Might there be another LTCM out there today? Could be. That's why these rare and dangerous potentialities are called Black Swans. You rarely see them. Until they're making headlines and terrifying everyone.
Of course, these days we seem to be compulsively on the look out for such events. Which rarely portends their occurrence.
Falling energy prices will help Christmas shoppers. Will hurt weaker shale producers. And will eventually rise again when the market dictates that prices should be higher. As it should be.
Meanwhile, patient observers will hone their lists of desired energy companies. Because at some point, these stocks will rocket off their lows like a Bakken oil gusher. Raining profits upon those with the nerve and gumption to take a chance.

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