Should We Be Worried about Plunging Oil Prices?

Oil price scenarios

Scenario planners tend to not sleep soundly when the economic news seems just too good. Specifically, we’re talking here about the sharp Thanksgiving week crude oil price-drop, amounting to a 40% fall in world oil prices since just this past June. It’s an early holiday present for consumers, with the welcomed effect of a modest tax cut, and it promises glad tidings for retailers and sellers across the economy. What’s not to like about that?

Indeed, there’s little question that the falling oil prices represent a timely shot-in-the-arm for consumers and for the global economy. For the U.S., lower oil prices could add 0.4% to the nation’s GDP, pushing growth in 2015 over 3% for the first time since 2005, according to data compiled by the New Yorker’s John Cassidy. Lower oil prices also strengthen the dollar and keep benchmark interests rates close to 0%. This is extremely reassuring news to builders, developers and companies just starting out, especially with the ongoing uncertainty around Fed phase-out of quantitative easing.

Outside the U.S., there is similar rejoicing in the eurozone, Japan and China, all of which are significant oil importers.  The more optimistic economists are forecasting that the global economy, helped by lower energy costs, could see growth hit 4% in 2015. This does not sound like a reach, considering a $40 fall in oil prices represents a $1.3 trillion shift from producers to consumers annually, as noted by the Financial Times’ Martin Wolf.

Where these low oil price scenarios gets murky is looking longer term at the effects on the losers – oil producers, at home as well as abroad. OPEC, at least for now, has decided against reducing output, but some of its members, namely Venezuela, have virtually no cushion against the revenue loss.  Nigeria is highly vulnerable as well.

Among non-OPEC oil producers, Russia has a contingency fund to protect itself against the oil price drop, but it can’t shield itself against reduced oil revenue indefinitely. The bigger immediate worry is that tighter economic conditions at home might paradoxically reinforce Vladimir Putin’s recent display of imperial ambition and the diplomatic militancy he so readily employs – an external threat is, after all, a time-honored and very dangerous way to divert domestic attention away from privations. But this could also have the positive, opposite effect of discouraging expansionist actions that might bring new, harsher sanctions or extend Russian military commitments beyond what they can reasonably sustain.

Closer to home, Mexico may be in for rocky times. It some ways, it feels a lot like 1986, another time of falling oil prices and peso instability. The currency has been under considerable pressure of late and is down 6% for the year.  Fortunately, Mexico’s foreign exchange reserves today appear healthy and, unlike 1986, oil revenue is hedged. But the nation is reeling from some of the most potentially grave political discontent in decades, following the murders of 43 teacher-college students last September.  Looking ahead, with declining oil revenue the government will have less fiscal freedom to ameliorate political tensions.

Finally, who in the U.S. loses in  low oil price scenarios?  Clearly energy companies that have made big investment in development of shale oil deposits. Make no mistake this is big business: About $9 billion a day. There’s considerable sunk investment in this activity, so production must continue in areas where the extraction infrastructure is well-developed (e.g., North Dakota). But with high production costs, the break-even point is very high.  Marginal producers are vulnerable. Even the big players are reportedly leveraged to the hilt.  It goes without saying that this entire sector, including suppliers and investors, should be watched very closely over the next 12-18 months.

But…who knows?

None of this should be taken as predictions of anything. Scenario-planning consultants know better than to predict much of anything beyond this afternoon’s weather.  Oil market forecasts are particularly dodgy, especially with so much production centered in the Middle East. Oil price scenarios can be transformed by a single event – an assassination or maybe just an inflammatory Tweet  could set in motion a highly destabilizing and unpredictable chain of geo-political events.  The return to oil prices over $125/bbl would then be the least of our worries.