The carnage in the oil square continues this morning. Yesterday the near month WTI contract was down over $2 and closed right at $50. That big round figure was blown out overnight as we are already down another $1.15 this morning. We are now trading at levels last seen in the depths of the 2008 credit crisis.
I had thought that the $55 level would hold, but that level’s support proved temporary. At this point I think it is safe to say that the decline has gotten out of control. Although at first the Saudis and the Americans welcomed the declining oil price as a way to inflict economic pain on Russia and Iran, the selling has taken a life of its own. We are now deeply entrenched in one of those Soros reflexive situations where the declining price is not creating more demand, but instead more selling. As the price declines, desperate crude producers are selling more oil to make up for the lower price.
There is considerable debate on what this dramatic decline in the price of crude oil means for the US and global economy. There are two schools of thought. The first and most obvious one is that the decline is uniformly positive for the economy. Consumers are net users of energy, so the lower price puts more money into their pocket. It amounts to a huge tax cut for the consumer. But there is another line of reasoning that argues that the decline in crude oil is by no means something to celebrate. This theory seems to be especially popular amongst the fast money hedge fund crowd. It can best be summed up by the following piece from the world’s largest hedge fund:
Bridgewater Associates, LP confirmed that lower oil prices will have a negative impact on the economy. After an initial transitory positive impact on GDP, Bridgewater explains that lower oil investment and production will lead to a drag on real growth of 0.5% of GDP. The firm noted that over the past few years, oil production and investment have been adding about 0.5% to nominal GDP growth but that if oil levels out at $75 per barrel, this would shift to something like -0.7% over the next year, creating a material hit to income growth of 1-1.5%.”
Proponents of this theme also point out that a bust in the energy sector might spread to the rest of the market. We have already seen a considerable widening of high yield energy spread levels. Just like the 2008 credit crisis was at first contained to the subprime real estate sector but eventually cascaded into the rest of the market, many pundits worry that the energy related selling is just the start of something bigger.
I am not sure that this comparison is fair. I came upon this great tweet that outlined the percentage of energy related names in the high yield market:
Don’t get me wrong, I think that the damage in the energy square is going to be massive. I am just not sure that it will necessarily spread to the rest of the market.
I am more concerned about what the declining oil price means as a reflection of the state of the global economy. Although I acknowledge that the oil price decline is largely a supply story, the severity of the decline worries me about the demand side as well. If the global economy was even remotely healthy this decline in price of oil would be met with increased demand as economic activity was ramped up. However this is not happening, and the lack of demand at these lower prices is especially troubling.
When you combine the plummeting oil price with the collapsing global bond yields, you are getting some strong signals that all is not well in the world’s economy. The hottest bond manager out there right now, Jeff Gundlach, touched on this idea in a recent interview.
Oil is incredibly important right now. If oil falls to around $40 a barrel then I think the yield on ten year treasury note is going to 1%. I hope it does not go to $40 because then something is very, very wrong with the world, not just the economy. The geopolitical consequences could be – to put it bluntly – terrifying.
Oil’s decline might be a symptom of a global economy that is spiralling downward.
I think that the market has gotten overly pessimistic about the price of oil, but so far I am wrong. Although I still wouldn’t buy energy stocks or bonds, I am sticking by my call that we chop around $55 to $70 for foreseeable future.
But I do want to highlight some important consequences of the low oil price. Although I am not sure if the low and middle class are going to spend the savings from the lower energy prices or not, there can be no disputing that the low energy prices are going to be a bigger relative benefit to the these groups than the “one percenters.” There is going to be some very demonstrable savings for the average American from the low energy prices. Energy is a big component of their daily expenditures. As for the “one percenters”, the savings will be small as a portion of their net worth, and as owners of the financial assets, they will actually be hurt by the falling price of energy stocks and bonds. Therefore the low oil price will be a step in the right direction in terms of arresting the growing inequality between the rich and everyone else. Not only that, but oil prices go into everything that is created and consumed. Think about it for a second. What item do you buy that doesn’t have oil as input? Whether it is actually created from oil, or energy is used in creating it, or the simple act of transporting it, energy is a major input in almost all goods. This massive decline in the price of oil will be extremely deflationary, and again, will help the non-“one percenters” disproportionally more.
The other interesting development from the low oil price will be the effect on non-traditional energy. The more than halving of the price of oil is a big blow to the development of electric cars. It can’t be good for solar, or wind energy either.
It will be extremely difficult with non-traditional energy sources to compete with oil priced at $50 bucks. I know that not all energy is easily exchangeable, but when the main storable energy source has declined by 55% in less than a year, it would be foolish to think it won’t pressure these other forms of non-traditional energy. For all those “greens” that were hoping to wean our economy off fossil based fuels, the process will be all the more challenging with the new lower oil price.
I am not sure if there are any actionable trades from these ideas. In the long run, the lower energy price is a big plus for the world economy. But I am worried that is a symptom of something really wrong from the demand side. For now I am long actual crude oil, and I wouldn’t touch energy stocks or bonds for some time to come. Sentiment is pretty negative when it comes to the price of oil, with lots of calls for $20 filling my twitter stream. Let’s hope these dire calls are going to mark the bottom.