God Help Us: Economic Memo #66

When I was in Little League, my father was not a coach or manager, so I was at risk of bad things happening. That was Strike One. In the championship game, I was playing first base, and a ball, if caught, would give us the championship, flew off the opponent’s bat and headed to the right field.  Now I knew the right fielder was always picking daisies. Back went the ball, farther and farther away. The kid put up his glove. The ball was right there. If he catches it, we win. Down it comes, two inches from his glove. Then the first baseman (who shall remain nameless) slams into the kid in an effort to catch the ball. It drops, two runs scored, and we lose. Strike Two. The next year I didn’t get to play when the team could have only one kid in my age bracket, which was the same as the manager’s son. Bad things happen when you get two strikes against you. It took a long time to get over it, and my son’s manager was always his dad.          

Remind me to tell you about the little league draft. That was a good one.         

So how is this relevant? Covid19 (strike one) and oil price war (strike two) are a real disaster to the economy.

Let’s talk about the oil price war first since it will have the most lasting effect and is the most significant effect. The price of oil dropped 10% on Friday, March 6, and March 8; it dropped another 25%. Now that’s good news at the pump for the consumer since the price of oil is 60% of the price, but bad news everywhere else. Remember, oil-related stocks are more than 3% of the S&P stock market index, and the bond market and stock market are tied inversely to each other. This means the oil price war will spill over to highly leveraged companies (some shale companies), and the market has a lot of uncertainty. The market does not like uncertainty.

To understand what happened, take a look at the graphs below.

Friday, March 6, the price of a barrel of oil was $45.70 (Point 1). Note, Russians and the Saudi’s for some time have been working together in what was called OPEC+ to maintain the prices.

Next, consider the impact of COVID19 on demand. The COVID19 projected impact was forecasted to reduce demand to $26 (Point 2). To maintain price, the Russians would have to agree to cut supply with the Saudi’s (and the rest of OPEC) to maintain $45+ (Point 3). Graphicly, the supply curve will shift to the left.

Here’s where the rub comes in. The Saudi breakeven point is estimated at $40, Russia’s is $42, and the US shale is $50.

The OPEC+ price support deal at $45+ before the knife fight also aided America’s shale industry. Keeping the price artificially high and close to the US breakeven point resulted in Russia being increasingly angry. The Trump administration’s willingness to employ energy as a political and economic tool upset Putin, and he wanted revenge by forcing US companies to go broke.

Putin was especially irked by the U.S.’s use of sanctions to prevent the completion of a pipeline linking Siberia’s gas fields with Germany, known as Nord Stream 2. The White House has also targeted the Venezuelan business with Russia’s state-oil producer Rosneft.

“The Kremlin has decided to sacrifice OPEC+ to stop U.S. shale producers and punish the U.S. for messing with Nord Stream 2,” said Alexander Dynkin, president of the Institute of World Economy and International Relations in Moscow, a state-run think tank. Of course, to upset Saudi Arabia could be a risky thing, but this is Russia’s strategy at the moment – flexible geometry of interests.”

In the short run, Russia is in a good position to withstand an oil price slump. The Russian budget breaks even at $42 a barrel, and the finance ministry has squirreled away billions in a rainy-day fund.

Nonetheless, the coronavirus’s impact on the global economy is still unclear, and with millions more barrels poised to flood the market, Wall Street analysts are warning oil could test recent lows of $26 a barrel.”

Saudi Arabia also has a rainy day fund and can withstand the Russian actions. In short, the Saudi’s decided to bring Russia back into the fold by increasing the supply and stressing the Russians at a very low price. The price war was on. To top it all off, the Russians may not run the US shale out of business. The Saudi’s tried this same strategy in 2016 and failed.

While many drillers in Texas and other shale regions look vulnerable, as they’re overly indebted and already battered by rock-bottom natural gas prices (a co-product of drilling the oil, significant declines in U.S. production may take time.

The largest American oil companies, Exxon Mobil Corp. and Chevron Corp., now control many shale wells and have the balance sheets to withstand lower prices. Some smaller drillers may go out of business, but many have bought financial hedges against the drop in crude. Another important fact is that the land leases are intact and long term, so shutting a well doesn’t mean the long-term loss of the drilling rights.

In addition to being bad news for energy stocks, pressure on oil prices promises pain on the credit front for leveraged companies. That adds to stresses in corporate debt that were already being amplified by the coronavirus outbreak, analysts said. Meanwhile, pressure on yields tied to the collapse in oil prices is also bad news for financial stocks, analysts said.

“Oil is a significant driver of GDP in Mexico Norway, Canada, Russia, Brazil and Colombia, and, of course, the U.S. is the world’s biggest oil producer in absolute terms now,” said Kit Juckes, global macro strategist at Société Générale, in a note.

“None of those countries’ currencies is going to have a good day though the dollar does still derive support from its reserve-currency status,” he said.

The Federal and other central banks are trying to dampen the effect of all this.

The coronavirus outbreak has spurred central banks to co-ordinate action, with growing fears in the market that a global recession could be looming. The Federal Reserve slashed rates by 0.50% last week, and the Canadian and Australian central banks followed suit with rate cuts. After the Fed rate cut, Fed Chair Powell said that he expected the move to boost the U.S. economy, which will likely be impacted by the virus. But the fact remains that things are going to get worse before they get better. “The range of potential outcomes is large and depends on the spread of the virus

About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at obrientr@lewisu.edu. Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

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