December 18, 2014

Concerns of lower oil prices on economy

Oil Prices Dropping

This is an event -- caused by weakening demand and rising supply -- that I strongly feel will hold negative consequences for the financial markets and for the profit levels of S&P 500 companies.

Subpar global economic growth produces a fragile condition, as more than one-quarter of the world's economies are experiencing a recession or under 1% in real gross domestic product growth. This, in turn, exposes the trajectory of economic growth to numerous exogenous shocks, be they geopolitical, currency-based -- as in a rising U.S. dollar -- or of a multiple-standard-deviation decline in energy prices.

As I expressed over the weekend in The Wall Street Journal, $58-per-barrel oil is sending a signal of slowing global economic growth. It represents, much like Penn Square Bank did in the early 1980s, the potential for contagion risk. It is also vividly underscored by the strength in utilities, in the bond market and in other fixed-income-equivalent equity sectors. 

As chronicled below, there are already substantive signs of stress in the credit markets. 

We have already seen the impact of lower oil prices on a vulnerable high-yield market. Last week, high-yield selling intensified as yields and spreads rose to more than two-year highs. $90 billion of the $210 billion worth of outstanding energy bonds are now trading below $90, and a contagion into non-energy high-yield has begun in earnest. The J.P. Morgan Domestic High Yield Index is now pricing in default rates of close to 5% over the next one-and-a-half years. 

I also remain concerned about energy bank loans. Commercial banks have started to trim the value of oil reserves tied to credit lines, creating pressure on some of the more leveraged energy enterprises through lessened credit availability.

Numerous exploration companies are cutting back exploration activity. I mentioned Oasis Petroleum  (OAS) a week or so ago, but others, such as Petrobras  (PBR) , have announced exploration cutbacks in order to shore up cash and preserve liquidity. Drilling activity has begun to fall rapidly -- and rigs targeting oil are experiencing the largest weekly drop since late 2012.

What has surprised me thus far is that there has been quite limited profit guide-downs in the oil patch. But profit cuts will be coming fast and furious in the weeks ahead. 

During the weekend, the head of the Organization of the Petroleum Exporting Countries (OPEC) said the organization has no fixed price target, but he thinks the decline has gone beyond levels justified by the market's fundamentals. On the other hand, a United Arab Emirates energy minister said OPEC won't change its mind on production "because prices went to $60, or to $40." 

The recent downside oil shock will also create a meaningful economic challenge to those countries that are dependent on higher energy prices. Not only will the price drop adversely impact countries' gross national product (GNP), it will also serve to threaten the ability to meet social spending targets -- and thus holds the potential for both economic (slowing global growth) and social unrest in 2015 and 2016.