The Fuse

Things Have Changed: Low Oil Prices a Threat to the U.S. Economy

by Matt Piotrowski | January 19, 2016

Low oil prices are threatening the U.S. economy. Yes, you read that right. The downside of becoming a “global energy superpower” is that with lower prices come economic pain.

The effects of oil prices on the U.S. economy aren’t as straightforward as they used to be. In the past, high oil prices have helped induce economic recessions, most recently in 2008, while low prices were a significant windfall to consumers. That still holds true to a certain degree. Motorists and energy-intensive industries are seeing significant cost savings from weaker prices, and price volatility and high levels still threaten economic growth.

There are currently worries that the U.S. or global economy will sink into a recession, with low oil prices cited as a key factor dragging down growth.

However, there are currently worries that the U.S. or global economy will sink into a recession, with low oil prices cited as a key factor dragging down growth. Just on Friday, many in the press linked the massive drop in the Dow Jones of almost 400 points with falling oil prices, which have tumbled by a massive 22 percent since the beginning of the year. Energy sector stocks in the S&P 500 have been pummeled by about 11 percent since right before Christmas. It’s not exactly clear, though, if the oil price is causing the downturn in stocks and prompting economic jitters, or the economic worries are instead pulling the oil price down. Whichever is the case, the two are closely linked and will feed off of each other, a ramification of the interconnectedness of all financial markets.

What oil gave the U.S. economy, it’s now undermining

It’s understandable why countries across the Middle East, as well as Russia, Venezuela, Canada, Brazil, and Norway are suffering, given how much their economies rely on oil import revenues. For the U.S., as a major oil consuming country, the low oil price is still able to cause pain, though not yet on the wide scale seen in the petro-economies.

For the U.S., as a major oil consuming country, the low oil price is still able to cause pain, though not yet on the wide scale seen in the petro-economies.

Low prices are undermining the economy for a number of regions. First of all, the oil sector is a huge employer, growing in particular in recent years because of the massive growth in shale oil output. Second, in regions where oil is produced, workers outside the industry are indirectly impacted by a downturn in prices. Third, major banks hold large amounts of debt from loans to oil companies, and there are worries about defaults now that oil prices have continued their downward trajectory. Lastly, stocks of major energy companies such as Exxon Mobil are allocated in investors’ portfolios and retirement accounts, and recent losses have caused consternation to anyone opening their latest 401(k) statement.

The shale boom’s boon is in major danger

The shale revolution, which took off at the beginning of this decade, has stimulated a large amount of oil production and inflated the role of the energy sector in the broader U.S. economy. Based on an analysis in 2013 by PricewaterhouseCoopers and the American Petroleum Institute, the oil & gas industries directly employ some 2.6 million, while estimates put the total number of jobs supported by the industry at almost 10 million. Moreover, the energy sector was one of the brightest spots in the recovery after the 2008 financial crisis. “After the end of the recession, between 2010 and the end of 2012, the industry added 169,000 jobs nationwide, growing at a rate about ten times that of overall U.S. employment,” wrote Stephen P.A. Brown and Mine K. Yucel for a Council on Foreign Relations paper in 2013.

The energy sector was one of the brightest spots in the recovery after the 2008 financial crisis, but a number of companies are going bankrupt and others are possibly on the verge of default.

The numbers have grown even more since then, but these jobs are obviously in danger, with a number of companies going bankrupt and others possibly on the verge of default. Some firms have already announced layoffs, with BP notably being one of the most recent, saying it would cut some 4,000 jobs globally. The Federal Reserve of Dallas said last month that oil and gas sector bankruptcies in the U.S. reached levels in the fourth quarter that haven’t been seen since the Great Recession. It added that at least ten U.S. oil and gas companies, which held more than $2 billion in debt, filed for bankruptcy in the fourth quarter alone, and warned of more to come this year.

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Oppenheimer’s Fadel Gheit said on CNBC that half of U.S shale producers could go bankrupt. He told The Fuse that he “was being generous” in that assessment and the destruction could end up being worse. There’s also the vulnerability of investment banks that have lent capital to the companies now in trouble. “There are worrying signs of bad habits [among banks] extending bad loans,” Gheit added, noting that today’s lending to oil companies is reminiscent of the real estate bubble last decade.

Banks will either have to incur huge write-offs or force companies to sell assets. Whatever the case, the oil sector’s pain is hitting banking, possibly putting that sector at a greater risk. Gheit suggests that banks “won’t pull the plug on oil companies so they can get something back from them.” Shale oil companies are the “walking dead, but banks want them to keep walking.”

Shale oil companies are the “walking dead, but banks want them to keep walking.”

If banks end up taking major losses like they did in 2008 when they were highly leveraged as a result of the housing boom, the oil market’s pain will have even greater repercussions for the overall economy.

Bloomberg reported last week that major banks such as Wells Fargo, Citigroup, and JPMorgan Chase altogether put aside a whopping $2 billion combined to cover bad energy loans and will increase this cushion if prices remain low. Losses for these banks are on the rise because of defaults and bankruptcies. Wells Fargo said it lost $118 million on its energy portfolio in the fourth quarter, while Citigroup lost $75 million.

Not all doom and gloom

It’s not all doom and gloom, however. While there is obvious turmoil in both the energy sector, the national labor market, just like shale oil production, has been remarkably resilient. That said, the states most sensitive to fluctuations in oil prices include Texas, Louisiana, Alaska, North Dakota, Oklahoma and Wyoming. These markets enjoyed boom times during the economic recovery, but are the most vulnerable at the moment.

“Overall, the drop in oil prices is a positive for the economy,” Mike Lynch of Strategic Energy & Economic Research (SEER) told The Fuse. “It’s just not good for a few sectors and some geographic areas.”

“The oil sector is losing some of the boom and cyclical inflation, but it is still keeping people employed,” Lynch said, noting that even though the rig count is down, employment is holding up. He points out that oil-producing areas of Texas are not “ghost towns” like they were in 1986, when prices fell to about $10. Even though the state is still highly dependent on the oil sector, which employs almost 2 million people there, the economy has diversified over time and won’t experience the same kind of pain seen 30 years ago. In 1981, oil and gas made up about 19 percent of Texas’ GDP, but in 2010 it was much lower at 7.8 percent. The number is likely higher now as a result of the dramatic production gains of the past five years, but the point is that Texas, along with other major oil-production states, have diversified their economies away from oil in recent decades.

Can low prices tip the economy into a recession? Not on their own, but the fact that a key sector that was instrumental in the post-2008 economic recovery is suffering is worrisome.

Since reaching its peak in October 2014, employment in the U.S. oil and gas sector has dropped by some 70,000 jobs, according to an analysis from the Dallas Fed. Despite the layoffs, the unemployment rate in key states is still low, signaling the carnage is not yet widespread. In Texas, for instance, the unemployment rate is still at a low 4.6 percent—although that is up from the low of 4.1 percent in August 2015. Meanwhile, in North Dakota where the prolific Bakken play is located, the unemployment rate continued to drop the second half of last year, and was around 2.7 percent at the end of 2015, the lowest in the country.

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Can low prices tip the economy into a recession? Not on their own, but the fact that a key sector that was instrumental in the post-2008 economic recovery is suffering is worrisome. With the overall unemployment rate at 5 percent and low pump prices providing a stimulus, the labor market and consumer sentiment appear healthy. But there are headwinds, and if history is any guide, when the banking sector becomes overleveraged, the fallout can be catastrophic. The stock market’s beginning to 2016 has not helped. We’re in for some more turbulent times.