What’s not to like about cheap oil? Well …

Cheap oil is no bless­ing for com­pa­nies that bet on high prices “This crash is a huge trans­fer of wealth”

Bloomberg Businessweek (North America) - - Conntents - Loder and Matthew Philips

“For any­one con­sum­ing oil, lower oil prices are a tax cut,” said U.S. Sec­re­tary of the Trea­sury Ja­cob Lew at the World Eco­nomic Fo­rum in Davos on Jan. 21. “It puts more money in peo­ple’s pock­ets. It ac­tu­ally has a pos­i­tive ef­fect.” Lew was try­ing to be re­as­sur­ing, with good rea­son. The day be­fore, crude prices had dropped to a 12-year low of $26.55 a bar­rel, down from $107 as re­cently as mid-2014. The rip­ple ef­fects in the stock mar­ket briefly wiped as much as 565 points off the Dow Jones in­dus­trial av­er­age. (Oil ral­lied back to $32 as of Jan. 27.)

Lew’s con­tention that dra­mat­i­cally cheaper oil is some­thing to cheer about makes a lot of in­tu­itive sense. China, the world’s largest oil im­porter, has cap­i­tal­ized on lower prices by stock­pil­ing re­serves; for all the coun­try’s prob­lems as its growth slows, en­ergy costs aren’t among them. In the U.S., con­sumer con­fi­dence is on the rise. The ben­e­fits of the price cut “hand­ily out­weigh the neg­a­tives,” says Ja­cob Ou­bina, se­nior U.S. econ­o­mist for RBC Cap­i­tal Mar­kets. “It’s just a mat­ter of when con­sumers and busi­nesses ad­just to this.”

The meme that cheap oil acts like a tax cut goes back decades. As early as 1983, law­mak­ers asked the Con­gres­sional Bud­get Of­fice to gin up es­ti­mates of the ben­e­fi­cial im­pact of fall­ing prices. Re­vis­it­ing the topic a few years later the CBO of­fered an in­struc­tive caveat: “It may be best not to re­fer to a ‘tax cut equiv­a­lent’ of an oil price change.” Among the rea­sons the anal­ogy didn’t work: The drop in rev­enue for do­mes­tic en­ergy com­pa­nies can trig­ger eco­nomic con­trac­tion not seen with a tax cut. And, sur­pris­ingly, the to­tal eco­nomic ben­e­fit ac­tu­ally shrinks the fur­ther prices fall.

In­creased U.S. en­ergy in­de­pen­dence has made the math even trick­ier. With do­mes­tic out­put near a 43-year high and fuel im­ports down to 24 per­cent of con­sump­tion, a glut of crude isn’t a prob­lem just for OPEC and Texas any­more. Thirdquar­ter rev­enue for U. S. in­de­pen­dents, the lit­tle com­pa­nies that drove the shale boom, was $26 bil­lion less than the year be­fore, ac­cord­ing

to data com­piled by Bloomberg. Last year’s spend­ing is on track to be more than $60 bil­lion lower than 2014, and oil at $30 a bar­rel has prompted a fresh round of cut­ting. Gold­man Sachs, which hailed lower prices as a $125 bil­lion tax cut in De­cem­ber 2014, put it this way in a Novem­ber re­port re­treat­ing from its bullish pre­dic­tion: “Shale states shrank the stim­u­lus” that usu­ally comes when con­sumers pay less at the pump.

In­stead of tax cut, some an­a­lysts are turn­ing to an­other sim­ile: Fall­ing oil prices could be like fall­ing real es­tate val­ues. “This was a Wall Street bet, and the bet was that the price of oil, a the­o­ret­i­cally fi­nite com­mod­ity, wouldn’t go below a cer­tain level,” says Martin Bienen­stock, co-head of bank­ruptcy and re­struc­tur­ing at law firm Proskauer Rose. “The bet turned out wrong. Just like the bet that hous­ing prices would never fall.”

Dur­ing the boom years, some shale pro­duc­ers spent $2 drilling for ev­ery $1 earned sell­ing oil and gas, ac­cord­ing to data com­piled by Bloomberg, and they plugged the short­fall with debt. Wall Street ex­tended low­in­ter­est credit lines to junk-rated bor­row­ers, which put up their oil and gas prop­er­ties as col­lat­eral. Pro­duc­ers tapped their bank lines to buy prop­er­ties and drill wells. When com­pa­nies needed to pay off their loans, their bankers helped them sell equity and debt. In­vestors, hun­gry for higher re­turns af­ter years of low in­ter­est rates, snapped it all up.

From 2004 through 2014, the high­yield bond mar­ket dou­bled in size while the amount of bond debt owed by junk-rated en­ergy pro­duc­ers ex­panded eleven­fold, to $112.5 bil­lion, ac­cord­ing to Bar­clays. Bond buy­ers were so ea­ger that pro­vi­sions meant to pro­tect them eroded.

It worked beau­ti­fully un­til oil prices col­lapsed. Rev­enue has plum­meted, leav­ing pro­duc­ers short of cash to pay their debts. Banks have cut drillers’ credit lines as the value of their col­lat­eral has fallen. Oil and gas bonds have pushed debt mar­ket dis­tress to lev­els not seen since the 2009 re­ces­sion, ac­cord­ing to Stan­dard & Poor’s, and bond buy­ers are sell­ing their hold­ings at steep dis­counts to sal­vage some part of their in­vest­ment.

Those who got out could be the lucky ones. Last year 42 U. S. oil pro­duc­ers went broke ow­ing $17 bil­lion, ac­cord­ing to the law firm Haynes & Boone, a trend that’s likely to ac­cel­er­ate at to­day’s prices. Many hold­ers of those com­pa­nies’ bonds will get noth­ing. Banks aren’t im­mune. Wells Fargo, Bank of Amer­ica, Cit­i­group, and Jpmor­gan Chase said this month that they’ve set aside at least $2.5 bil­lion to cover po­ten­tial losses on sour­ing en­ergy loans. If low prices per­sist, the price tag will get big­ger.

The worry is that the pain spreads from fi­nance to the broader econ­omy. “Con­sumers may be do­ing great un­til pro­duc­ers can’t ser­vice their debt,” says Michael Feroli, chief U.S. econ­o­mist at Jpmor­gan. “And that creates prob­lems for ev­ery­one, pro­duc­ers and con­sumers alike.” He points out that the com­mod­ity bust of the 1980s con­trib­uted to the in­abil­ity of emerg­ing­mar­ket coun­tries to pay their debts, with world­wide con­se­quences.

Oil-rich coun­tries that spent the boom years col­lect­ing bonds, eq­ui­ties, depart­ment stores, and soc­cer teams are in sell­ing mode. As they dump as­sets, ex­ac­er­bat­ing the mar­ket rout, “it feels pretty messy,” wrote David Zer­vos, chief mar­ket strate­gist for Jef­feries Group, in a Jan. 18 re­port. Saudi Ara­bia, the world’s largest oil pro­ducer, has seen its for­eign ex­change re­serves fall by more than $100 bil­lion since mid-2015, ac­cord­ing to the Saudi Ara­bian Mon­e­tary Agency, a big­ger drop than dur­ing the fi­nan­cial cri­sis.

“But out­side the en­ergy mar­ket, this is noth­ing like 2008,” Zer­vos added. “This crash is a huge trans­fer of wealth away from the lev­ered global en­ergy as­set holder to the un­lev­ered av­er­age con­sumer.” Sim­i­larly, RBC’S Ou­bina calls com­par­isons to the sub­prime bust “in­san­ity.” The fi­nan­cial sys­tem, he says, “is iron­clad com­pared to 2007.”

There’s one more thing low oil prices might be like: a flash­ing red warn­ing light. China’s down­shift to an­nual growth of 6.8 per­cent, from 10 per­cent five years ago, is a big fac­tor pulling oil prices down. It points to an in­creased risk of de­fla­tion and slow growth through­out the global econ­omy. In other words, per­sis­tently low oil prices could re­ally be just a symp­tom, says Jpmor­gan’s Feroli. “This may be the re­sult of a bad econ­omy,” he says. “Not a cure for a bad econ­omy.” �Asjy­lyn The bot­tom line While cheap oil has ben­e­fits for con­sumers, de­faults by pro­duc­ers and pain in oil­rich coun­tries could stall the world econ­omy.

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