Plunging oil price is far from the economic balm it used to be
The idea that cheap oil can help the global economy in its time of need isn’t clear-cut right now.
It means lower fuel costs for households and business, but the savage drop in oil prices can also filter out in less positive ways. Morgan Stanley economists note it will hit the investment outlook in the energy sector, adding another drag on growth amid hits to multiple industries and countries from the coronavirus.
The pros-and-cons debate has been sparked by the biggest drop in Brent crude oil this century. Prices plunged more than 30% Monday after a split between Saudi Arabia and Russia on production led to an all-out price war. Those taking the positive side see the drop as a shock absorber for the economy. Adam Posen, president of the Peterson Institute for International Economics, says it’s a “critical mechanism on the global economy righting itself.”
The world economy was already under pressure before the coronavirus outbreak spread from China to more than 80 other countries and territories. Shuttered cities, widespread flight cancellations and shaken financial markets are putting further strain on businesses. Add to that market volatility that’s led to a tightening of financial conditions and many are worried about a recession, at least in the short term.
In addition to the hit to energy investment, the Morgan Stanley economists are also less optimistic about the benefits to demand from lower oil prices. According to analysts including Chetan Ahya, they won’t be fully realized because it’s coming at a time of an “overall downdraft.”
At Goldman Sachs, it’s not a clear-cut story either. For all the consumer upside, there’s a corporate downside as energy producers struggle with margins.
“Economists often emphasize the positive effects of lower oil prices for the consumer via higher real income, which are real,” said Jan Hatzius, Goldman’s chief economist. “But in some economies – most importantly the U.S. – they are largely or entirely offset by the negative effects on the oil-producing sector.”
What Bloomberg’s Economists Say
“This time around the net impact might not be so positive. Producers will still lose… Consumers will gain, but with the risk of a coronavirus-induced shutdown looming, they might not have the motive or opportunity to divert their energy savings to other spending.”
– Tom Orlik. Read the full Global Insight
Investors have reacted fast. The average spread over Treasuries for companies in the Bloomberg Barclays High Yield Energy index surged above 10% for the first time since 2016, a threshold typically associated with distress.
Federal Reserve Bank of Dallas President Robert Kaplan also saw benefits to U.S. households being weighed against the drag on investment.
“We said before the coronavirus that energy capex in the United States would be down as much as 10-15%. This obviously makes it more challenging,” Kaplan said in an interview on Bloomberg Television Thursday. “So I think you will see some defaults, some restructurings, cutbacks and reduced drilling activity in the energy sector.”
The U.S. shale oil industry, already laden with debt, could be a big loser. West Texas Intermediate dropped below $30 a barrel at one point Monday, a level at which vast swaths of that sector become unprofitable.
But Harry Tchilinguirian, BNP Paribas’s head of commodity research, says the pain may not be as bad as feared, as the industry is relatively well hedged – though there will still be damage.
“Some of the smaller producers who aren’t hedged are going to feel the pain of $30 because that would would be significantly below the breakeven prices,” he told Bloomberg Television.
According to BNY Mellon Investment Management, every $10 fall in oil prices transfers around 0.3% of world gross domestic product from oil producers to oil-consuming nations. But the question is if any gains are spent to offset the losses elsewhere.
“The boost is unlikely to be large enough to stabilize a world economy faltering from the impact of Covid-19,” said Shamik Dhar, chief economist at BNY Mellon. “But low oil prices could prove a favorable environment once the impact of the virus has passed later this year.”
Researchers studying the collapse in oil prices from above $100 a barrel in 2014 found that the reduction in energy costs in the U.S. helped offset the economic impact of lower energy-sector investment by generating an income windfall for U.S. consumers.
“Even in the oil-producing U.S., the lower price is a stabilizing force for output today,” Posen said. “It shifts some of the adjustment to the shock from the consumer and service sector to the energy sector. Spreading the pain is how economies adjust.”
– With assistance from Steve Matthews.