"No warning can save people determined to grow suddently rich" - Lord Overstone

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Oily Trouble Ahead?

Charts created using Omega TradeStation 2000i. Chart data supplied by Dial Data

Consumers are most likely elated about the recent drop in oil prices that has quickly translated into a drop in gasoline prices. It could also help the economy. The IMF has calculated that a 30% drop in oil prices could boost GDP by 0.8%. The drop is estimated to have transferred $1.5 trillion from producers to consumers. The drop in oil prices so far since June 2014 has been roughly 39%

As oil declines go, it has not been that much. Dollar wise at over $40 it is the largest decline since the 2008 monster decline. That decline saw WTI oil prices fall $114 in the space of roughly six months. Percentage wise at 39% it is small when compared to the big declines seen over the past thirty years. The 2008 oil crash holds the top prize with an astounding 78% collapse.

Sharp rises in oil prices have often preceded recessions. But what about oil price collapses? Oil as I am sure everyone knows is probably the most political commodity. Since the Arab Oil Embargo of 1973-1974 that came because of the Yom Kippur War and the US's aid to Israel, oil prices have undergone a series of sharp ups and downs over the years triggered mostly by conflict and price wars.

The Arab Oil Embargo also brought the world the "Petro Dollar" and the bargain between Saudi Arabia and the US that in exchange for arms and protection all future sales of oil would be priced in US$. Other OPEC countries agreed and the rest of the world followed not only pricing oil in US$ but all commodities and world trade. Prior to 1973 oil was generally priced in US$ but it could also be exchanged in local currencies. The Saudi's would act as a guide for pricing as they were best placed to increase or decrease production to suit market conditions. The Saudis also agreed to recycle their surplus US$ to the US through the purchase of US Treasuries.

Today major oil exporters led by Saudi Arabia hold roughly $280 billion of US Treasuries or 4.6% of the total held by foreign entities. At one time, it was considerably higher percentage. China and Japan are the two largest foreign holders of US Treasuries with $1.3 trillion and $1.2 trillion respectively. That represents roughly 41% of all US Treasuries held by foreigners and almost 14% of all US Treasury notes, bills and bonds.

Since 1980 there has been six significant oil price collapses. 1979/1980 saw the Iran hostage crisis and the start of the Iraq/Iran war. Price collapses have followed price spikes. Price collapses are just as a destabilizing as price hikes. They could be a sign that something is amiss.

The Iranian hostage crisis and Iraq/Iran war had triggered a sharp increase in the price of oil from $12-$15 in 1977-1978 to $40 by May 1980. Since the outset of the Yom Kippur War and the Arab Oil Embargo oil prices had moved from $3.50 to $40 an incredible 1,040% increase. Saudi Arabia tried to stabilize prices in the first half of the 1980's through production quotas as there was a fear that the sharp increase in oil prices could destabilize the western economies and trigger a depression. The 1974-1975 recession and the period to 1980 that saw inflation soar along with interest rates resulted in the severe 1980-1982 recession. Saudi Arabia eventually gave up trying to control production quotas and in late 1985 started an all-out price war by increasing production 3 million barrels a day.

The result was a 70% collapse in oil prices to near $10 from $32 in November 1985. This period also coincided with the Plaza Accord of September 1985 to bring down the value of the US$. The flow of US$ into the US as a result of the production hikes helped push the US stock market sharply higher and the end result was the October 1987 stock market crash.

The next crisis was Gulf War 1 when Iraq's invasion of Kuwait in August 1990 triggered a UN authority to eject Iraq. At the time, Russia and China did not exercise their veto and a coalition of forces primarily led by the US ejected Iraq starting in January 1991. The war lasted three months. Oil prices collapsed roughly 60% following the price spike to $41 because of the Iraqi invasion of Kuwait. The combination of sharply rising oil prices and the oil price collapse led to the early 1990's recession. Oil prices bottomed in 1994 near $14.

While increased demand helped oil prices to recover to near $27 by 1997 the Asian financial crisis and what was known as the Asian contagion and the fear of a huge drop in demand oddly triggered another OPEC production hike led by Saudi Arabia of 2.5 million barrels daily. The result was another price collapse from roughly $27 in late 1997 to about $11 by November 1998 a drop of roughly 60%. The destabilizing effect triggered another round of Asian contagion and debt defaults particularly Russia and the near collapse of the financial system when a huge hedge fund known as Long Term Capital Management (LTCM) nearly brought down the western banking and financial system. The collapse was prevented by a bailout of the banking system by the large US money center banks and massive injections of liquidity by the Federal Reserve.

OPEC again led by Saudi Arabia slowly cut production and prices recovered to almost $38 by September 2000. The sharp price rise triggered another round of production increases in order to bring prices down and that coupled with the emerging high tech/internet collapse and economic slowdown triggered another 56% collapse in oil prices to about $17 by November 2001. The events of 9/11 did not help as the Fed injected huge amounts of liquidity into the financial system to prevent a potential financial meltdown.

In March 2003 came the start of Gulf War 2 as a coalition led by the US invaded Iraq under what proved to be the false auspices of weapons of mass destruction (WMD). The invasion did not have UN authorization. This triggered an oil price rise and with rising demand from Asia coupled with growing constraints in production capacity and hurricanes that disrupted production, oil prices embarked on a spectacular rise to almost $147 by July 2008. The rise started at roughly $25 at the time of the invasion of Iraq.

The onset of the sub-prime crisis in July 2007 and the fear of recession coupled with falling demand because of the sharp rise in oil prices triggered the most spectacular oil price decline ever. Prices fell from $147 to $32 in the space of five months or so, a collapse of 78%. This coupled with the financial crisis of 2008 triggered huge losses in the oil sector globally and caused considerable problems for the oil patch in Western Canada.

Rising oil prices as a result of war have been behind the jumps in 1980, 1990 and into 2008. The subsequent collapse in oil prices is not necessarily associated with a recession but it is a sign of potential weakness. Oil prices recovered from the 2008 collapse and by May 2010, they were back up to about $87. The war against Libya helped push oil prices back up over $100 and combined with the uncertainty caused by unrest in a number of Mid-East countries due to the Arab spring, plus the civil war in Syria and the ongoing dispute with Iran over its supposed desire to build nuclear weapons, oil prices generally held between $90 and $110. Until now that is.

Oil prices have dropped over $40 since June. There are winners and losers. The winners are the importing countries like the EU, the US (who remains a net importer), Japan and China. Since oil is priced in US$ the fact that the Euro and Japanese Yen have both fallen in value since June offsets some of the gains from lower oil prices. The losers are the exporters like Russia, Venezuela, Nigeria, Iraq, Iran and other Mid-East countries like Saudi Arabia, and, oh yes Canada. Canada is split - it hurts Alberta and Saskatchewan, but it helps Ontario and Quebec and their manufacturing base. Airlines and consumers are the other big winners.

But the drop in the price of oil could have a destabilizing effect on financial markets. Energy companies, it seems, make up roughly 20% of the junk bond market of $1.5 trillion. The shale oil boom has been quite important to the US. It has moved the US to the top of the pack as the world's largest oil producer ahead of Saudi Arabia and Russia. The shale oil boom has created billions in investment and created hundreds of thousands of jobs. It has lessened US dependence on imported oil, although it has by no stretch eliminated imports. The shale boom has contributed to growing global production even as demand has softened in Japan and the EU as they both appear to be falling into recession.

By refusing to cut production and incrementally increase production, Saudi Arabia appears to be signaling a possible price war against US shale producers. It costs a lot to produce shale oil, generally over $80. Saudi Arabia and other mid-east countries can produce oil at substantially lower prices. Some put Saudi production costs at around $30. The Saudis have done this before to allow them capture or maintain market share while hurting others as they did in production increases during earlier oil price collapses.

Others say that the reason oil prices are falling is because of collaboration between Saudi Arabia and the US to hurt Russia because of the ongoing conflict in Ukraine. Some say Russia needs $105 to maintain their programs and cover their costs of production. While the Russian angle has credence one has to wonder why the US would also want to hurt their shale industry and by extension hurt the Canadian oil industry particularly oil sands production. It is possible that they were willing to accept some collateral damage and that the risk of creating a financial crisis was low.

Once an oil price war gets underway there is the potential for unintended consequences. An economic war against Russia may make sense to some but Russia is the world's 8th largest economy and does have the capability to hit back. Already as a result of sanctions Russia has moved closer to China closing huge energy deals. Sanctions are biting back against the EU economy that is now showing signs of moving into recession.

There is the potential for trouble within the EU itself. The cancellation of the South Stream pipeline that was to be built by Russia's Gazprom in conjunction with a number of EU companies has caused a rift in the EU as the countries that were to benefit - Bulgaria, Hungary and Serbia are upset as they stood to benefit considerably.

The decision was made in Brussels despite the objections of Bulgaria and Hungary both EU members. EU companies involved in the project are projected to lose €2.5 billion. The pipeline would have provided a secure supply of gas largely for southeastern Europe. As well it would have taken pressure off having to use Ukraine as a transit for Russian energy where there is already further trouble developing that could effectively cut off energy to the EU. There are potential alternatives but none of them were as advanced as South Stream. South Stream instead is to be diverted to Turkey. The cancellation of the project is being called by many as a lose-lose.

One thing to keep an eye on is junk bond spreads. Spreads on junk related debt (high yield CCC or below) has already moved from roughly 640 bp over US Treasuries to almost 900 bp over. That is a far cry from 3670 bp over seen in November 2008 and the 2450 bp over in September 2001. Spreads have widened for BBB related debt as well from 143 bp over to 178 bp over since June 2014. Spreads were 785 bp over in November 2008 at the height of the 2008 financial crisis.

Sharp increases in oil prices and sharp declines in oil prices have in the past translated into trouble in the broader economy. Recessions and stock market crashes have occurred. Since 1980 there has been four official recessions - 1980-1982, 1990-1991, 2001 and 2007-2009; and five sharp stock market corrections - 1980-1982 down 24%, 1987 stock market crash down 30%, 1990 stock market drop down 10%, 2000-2002 stock market crash down 46% and 2007-2009 stock market crash down 53%. Each recession or stock market drop occurred following sharp increases in oil prices or sharp drops in oil prices.

While consumers are celebrating lower gasoline prices the news in behind is not necessarily good. While there could be lags, the most recent collapse in oil prices is most likely signalling that there is oily trouble ahead.


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