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Friday, November 28, 2014

The importance of oil to the U.S. economy

I have seen a number of articles on the oil patch situation lately.  There is a huge amount of money being spent globally on energy projects.  From CAPEX Spending In The Energy Sector Keeps On Growing I found this.

Investment bank Barclay’s (NYSE:BCS) latest report on CAPEX budgets, the energy industry is expected to spend a whopping $723 billion on exploration and production (E&P) efforts in 2014. That’s nearly a 6.1% jump over 2013’s total CAPEX spending and will surpass the $700 billion-mark for the first time.
According to the survey of 300 energy firms, the bulk of that spending will occur in overseas fields. Roughly, $524 billion will spent on tapping new wells in places like offshore Africa and Middle East. However, North America will see the lion’s share of rising spending- roughly a 7% increase- as firms like Range Resources (NYSE:RRC) -continue to tap America’s shale formations.  

A 7% increase in spending in the U.S was probably significant in the boost to GDP we have seen this year.   Here is an interesting chart on U.S. oil production.

We are producing the most oil per day since the 1980s.  That is really some upturn in the chart the last few years.  I think this explains why Saudi Arabia which has been the largest oil producer for decades might feel a bit threatened.  I think they will be glad to stand by and watch the oil price drop.
This chart shows the break down of various sectors in SPX and their CAPEX and R&D.

The Energy sector has been the biggest chunk since 2006.  The total for 2013 was a little above $200 billion.  That is not chump change in our economy.

"The Energy sector accounts for roughly one-third of S&P 500 capex and nearly 25% of combined capex and R&D spending," Goldman Sachs' Amanda Sneider writes.

There is high paying jobs and expensive equipment involved in the process.  The energy sector has been a big boon to the U.S. economy and is probably the key reason why we are leading the developed world in growth.  I have already seen quite a few companies announcing plans to reduce expenditures next year based on the current oil price drop.  I have seen a number of significant price drops in my lifetime and none of them stopped until OPEC announced production cuts.  In the oil crash in 2008 they did not cut production until Dec. of that year.  So far no major producer is blinking.  Some countries like Libya are still trying to increase production.  I don't think we are anywhere near the bottom yet.

How will a major drop in oil prices affect the economy?  The reduction in CAPEX will clearly be a drag while the consumer will have extra money to spend.  This is rather complicated to figure out exactly what the affect will be.  Lets look at some numbers.  I think the most worrisome to me is the amount of junk bonds related to energy plays.  Check out this chart.

The U.S. junk bond market was around $1.3 trillion at the end of 2013.  That makes the current energy part roughly $200 billion in 2014.  What is particularly disturbing is the big surge this year (5% of $1.3 trillion is $65 billion).  That is a lot of fresh money allocated at much higher oil prices.  Have those borrowers even had time to get production going?  Since these were junk bonds the borrowers were clearly of marginal quality.  It seems likely there will be considerable defaults coming.  That could choke up the bond market once again.  Anybody remember the big oil bust in Texas in the 80s? Remembering Oil Bust of 1986 Reminds U.S. Drillers of Price War Risks  That lead to the savings and loan crisis that the government ended up having to bail out.  The U.S. economy did not go into recession over that crisis.  However, that may not be the case this time.  The PC revolution was powering the U.S. economy ahead in a big way and was totally unrelated to oil.  The economy today is barely growing above stall speed and actually is pretty weak in areas of the country away from the energy plays.  I believe an energy bust of that magnitude would have a much bigger impact on the U.S. economy this time.

The drop in oil prices is great for everybody outside of the energy world.  Lets look at some numbers.
The most recent estimates say the average U.S. household (about 115 million of them) uses 1200 gallons of gas.  That means every .10 drop in the gas price gives American consumers approximately $14 billion a year of extra money.  From the peak earlier this year the gasoline price has dropped about .90 which gives us about $124 billion of savings over the next year.  During the crash of 2008 gas prices briefly dropped under $2 for several months.  We could still see significant further declines in the gas price.  That is certainly a sizable amount of money.

There are pluses and minuses to the drop in oil price.  It is clear the junk bond market could be real trouble.  The so called search for yield caused by the ultra low rates from the FED has caused a lot of  money to flow into questionable places.  Keep in mind that the entire energy industry is highly leveraged.  Every well drilled is done with borrowed money.  Therefore the potential trouble in the bond market goes well beyond junk bonds.  A bust similar to the 80s will put many marginal companies out of business which will mean a loss of jobs along with defaults.  It is clear there is a significant risk to the economy should the oil price decline last.  With nobody shutting in production and additional drilling projects ongoing and coming online it seems highly likely the price decline will continue and will last for quite some time.  The economic growth from the savings of lower gas prices is a one shot deal.  Once prices level out there will be no additional savings.  The continued savings should benefit consumer spending, but won't really add to growth.

All in all it looks like the risks to the economy are greater then the benefits of the lower prices.  A bust will definitely cause major problems in the bond market which tend to have serious affects in the broad economy.  With the oil price in the 60s the higher cost producers are already in trouble.  From I have read an oil price in the 40s would be trouble for everybody.  I suspect we will get there at some point.  We are currently producing about 1 million barrels more per day then we use in the world.  It looks like nobody is cutting and additional production is coming on line every day.  There will be downward pressure on prices for quite some time.

I think the numbers involved with the energy industry indicate there will be significant negative economic affects from the rapid oil price decline.  While the savings to consumers is also significant it is spread out over long periods of time  The marginal energy players are already in trouble now.  Further price declines will only make that worse while adding more players to the troubled list.  I have not seen specific numbers, but I have read several times that many of these energy companies have been cash flow negative for years even at the higher oil prices.  I have heard people claim there won't be any trouble for 6 months or more because of producers being hedged with futures.  However, the futures data shows less then 250,000 contracts net short by commercial hedgers.  At 1000 barrels per contract that means 250 million barrels are hedged.  As per the chart above we are producing 9 million per day which is roughly 270 million per month.  Doesn't that suggest there could be trouble well before 6 months?  Keep in mind the size of the numbers globally indicate a cut in CAPEX spending could be a significant world event.

I have to admit I did not really see an oil price crash coming.  I kind of think most energy companies were also caught by surprise just like the 80s.  We know from past history that the decline so far (30 some percent) is not really unusual.  There have been a number of 60-80% declines in the past.  I find it interesting that the stock market internals started falling apart in early July at the same time oil started its meltdown.  Is there a connection?  Is the fall in oil possibly a black swan event because hardly anybody saw it coming?  The numbers show this could be a significantly negative event for the economy as odd as that sounds.  It could start feeding into the economic data at any time.  Maybe the oil patch was responsible for the unexpected increase in jobless claims this week (pure speculation at this point).  It certainly needs to be watched.


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