An article on the front page of The Wall Street Journal Business & Finance section yesterday read “U.S. oil prices sank deeper into a bear market Tuesday, posting their steepest fall in over three years and a record 12 consecutive days of declines, as fears of oversupply and weakening demand gripped the market.” A headline like this may have seemed inconceivable back in early October when the economy was supposedly firing on all cylinders and oil had risen to nearly $75 per share. But since the peak on October 3, the price of oil has dropped over 26% to a little over $56. The supply part we get. US oil production, along with that of OPEC and Russia, has been ramping quite dramatically. At the same time, the expected supply disruption from Iran resulting from economic sanctions has not been as bad as feared. And finally, President Trump recently urged OPEC to forego a production cut designed to avoid oversupply. All these factors have contributed to fears of an oversupplied market.
What is undoubtedly more confounding to investors is the softening in oil demand that has transpired in just the past few weeks. It is true that one source of lower demand has been a stronger dollar, which makes oil more expensive for non-US buyers. But US economic growth, boosted in large part by fiscal stimulus, has been trending at a 3% pace this year – well above the 2%+ average since the end of the Great Recession. Trends outside the US have clearly been less impressive, with particular concern about an economic deceleration in China. Still, despite all the hand-wringing, China put up 6.5% economic growth in the third quarter. If only we could all be so unlucky! Japan and Europe seem stable, if lackluster.
The bigger worry is the outlook for 2019. There are a number of concerns that are beginning to accumulate, each of which has the potential to threaten the economic stability we’ve heretofore enjoyed. Among these risk factors we’d include an intensification in the trade war with China (tariffs may be lifted to 25% from 10% in January); rising interest rates in the US and diminishing monetary support outside the US; the waning effects of US fiscal stimulus; the impact of a rising dollar on US growth; the impact of a rising dollar on emerging-market debt; Brexit-related uncertainty; and the Italian debt crisis and its spillover effects. Could these concerns be putting additional pressure on oil prices? Sure. Commodity prices are influenced by speculation just as they are influenced by near-term supply and demand.
Lower oil prices are not only an indicator of a softening economy, but they can also contribute to economic deceleration. We have all heard about the economic booms that have occurred in places like North Dakota’s Bakken and Texas’ Permian Basin. These booms, made possible by technological advances that enable drilling through shale, have been creating many high-paying jobs that provide positive ancillary effects for not only those geographic regions but also for the economy at large. A sustained drop in oil prices would undoubtedly crimp growth expectations for the US energy sector, and this drag could spread to other sectors just as the positive effects of higher oil prices affected the economy in a positive way. A couple other puts and takes: Lower oil prices usually translate to lower gas prices, which would have a positive impact on the consumer’s financial well-being during the critical holiday season. However, there has also been a spike in natural gas prices just as the price of oil has plummeted. This spike – which is being attributed to record demand, historically low storage levels ahead of winter, and the early arrival of cold weather – may offset some of the positive effects of lower crude oil prices.
Finally, there is another concern with lower oil prices. Many of the domestic energy producers, particularly those that concentrate in the seven major shale basins, issued a lot of debt so as to maximize production (and profits) as oil prices rose from depressed levels over the past couple of years. Now that oil prices are falling, some of these companies may find it more difficult to service their debt. This same issue became a significant drag on US economic growth in late 2015 and early 2016. But the price of oil eventually rebounded, providing relief to the oil companies. Now, though, it may be more difficult to recover as supply seems more abundant and interest rates continue to rise.
Thus far, the deterioration in the bond markets has been relatively contained, but other sectors of the bond market could become infected. It is possible that the energy-sector stress may spread as private companies compete with the federal government for investor dollars in the midst of trillion-dollar federal budget deficits. The massive amount of corporate debt currently outstanding does not help the outlook either. According to an article on Bloomberg Tuesday (“Credit Markets are Bracing for Something Bad”, by Robert Burgess), “The Institute of International Finance puts the corporate debt-to-GDP ratio at about 72%, which is just below its all-time high in early 2008.” Other concerns stem from the fact that there are record amounts of BBB-rated paper outstanding, which is the lowest rating to qualify as “investment grade.” Widespread downgrades resulting from economic deterioration could set off a selling wave by bond managers who are restricted by their charters from buying non-investment-grade paper. And finally, the recent high-profile volatility in GE bonds (and stock) does not bode well for confidence given that company’s massive presence in the debt markets.
The good news, as Burgess’ article in Bloomberg points out, is that lower oil prices should help contain inflationary pressures. The transportation sector in particular will welcome lower fuel costs as labor shortages have driven up their wage expenses. The recent increase in the dollar should also keep inflation from rising too much. As the Fed feels more comfortable that inflation is under control, it will likely slow its interest-rate increases. Given the amount of debt in the system, that will be a huge relief to all!