SI Férique

 

February 10, 2015

 

Markets struggling to adjust to new oil environment

 

Crude oil prices continued their downtrend during January. West Texas Intermediate closed the month at USD $47.79 per barrel, down 10.6%. Volatile energy markets, which continue to seek a bottom, have left investors trying to assess the implications. So far, resource heavy Canadian equities indexes have suffered the most in relative terms, while the US has performed well.

 

Conventional Canadian and American economic wisdom regards oil price declines similarly to tax cuts, in the sense that they put money directly into consumers’ pockets. In December one American analyst estimated that annual savings to consumers, particularly drivers, would equate to a $62 billion annual cash injection into the country’s economy.

 

Here in Canada, homeowners, many of whom use oil heating also benefit, as do manufacturers for whom oil is a major input. Canadian exporters, concentrated in Quebec and Ontario, are also big winners. Falling oil prices have driven down the value of the loonie from its USD $0.94 peak last year, to under USD $0.80 in early February. This equates to a vast price cut for Canadian goods in US markets and countries whose currencies are tied to the US dollar (such as China).

 

The energy sector takes a hit

The picture is far less rosy for Canada’s energy sector. Alberta’s tar sands players are high cost producers, many of which can’t make money in the current environment. Drilling activity has thus been slowing, companies have been shelving expansion projects and the Alberta government is adjusting to a projected multi-billion dollar revenue decline.

 

The US fracking industry, whose productivity contributed to the supply glut which caused oil prices to decline, is also suffering. While the industry is not a large part of the US economy, the four major states in which frackers operate, particularly Texas and North Dakota, accounted for a large part of the country’s new job gains during recent years. Furthermore most of those jobs were high paying and thus generated large spin off effects.

 

However the sudden price drops have made future drilling unproductive in many marginal sites and key players have already announced large layoffs. Another wildcard remains the effect that possible bond and loan losses would have on US financial system investors, many whom poured funds into fracking industry debt at extraordinarily low yield spreads, due to the current tight interest rate environment and the resulting lack of options available elsewhere.

 

How far will prices go and how long will the decline last?

The ultimate effect the current oil price slump will have depends on two factors: how low will prices go and how long will they stay there. One large US bank, echoing comments by a Saudi oil official, recently suggested that prices may ultimately reach as low as USD $20 per barrel. While that may well occur there are only a few international producers able to make money at those rates.

 

Even if oil prices do fall further, how long they would stay there remains an open question. Oil industry professionals remember that during the post 2008 financial crisis WTI oil fell from USD $140 per barrel to just $40 per barrel in the space of a few months. However supply tightened as unprofitable producers shut unproductive wells and within two years prices had bounced back to more than $100 a barrel.

 

 

 

 

peter@peterdiekmeyer.com

 

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