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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Energy Investors May Have A Long Wait Ahead

Energy Investors May Have A Long Wait Ahead

One of the great ironies of the oil crash has been the inability of economists and financial commentators everywhere to decide if the crash is good or bad for the global economy.

Historically, most economists agree that higher oil prices are a negative for consumers and that the economy should get a boost as oil prices fall. Yet, economic data for the U.S. over the last year has been tepid at best despite the “stimulus” effect of falling oil prices.

Part of the explanation for this apparent quandary is that the U.S. economy’s relationship with oil prices is no longer so simple. Up until about a decade ago, energy production in this country was a relatively small industry. Oil majors were enormous of course, but much of their production came from outside the U.S. That has all changed now. Related: Congress To Lift Oil Export Ban Next Month?

The U.S. is now a mega-oil producer, one of the largest in the world. The difference between the U.S. and every other major producer is the structure of our production markets. Rather than relying on a few large national producers, the U.S. has hundreds and even thousands of small producers. And as a result, the drop in oil prices has hammered the profits of those thousands of companies. The result has been nearly 200,000 in job cuts around the world, and $180 billion in capex cuts globally.

Using a standard macroeconomic multiplier of 2.5x – this suggests that total economic impact of the lost capital investment has been more than half a trillion dollars. The hit to publicly traded firm’s market caps has been an additional $1.3 trillion. This represents a substantial wealth loss for the economy as a whole.

Overall then, the effect on the U.S. economy is likely somewhere around $1.6 trillion (not all global capex cuts directly impact the U.S. – perhaps half do though, as a rough estimate). The positive effects on the economy from lower gasoline prices are not trivial, but they aren’t front end loaded in the way that capex cuts and stock wealth destruction are. Economists have estimated that lower gasoline prices add perhaps $100-$125 billion in economic stimulus to the U.S. economy, but that effect pales in comparison to the wealth loss and economic activity loss from lower prices. Related: When Will Oil Prices Turn Around?

The good news for the overall economy is that, with the wealth loss largely out of the way, and most capex cuts likely done, the hit to economic growth should abate by the end of the year.

Firms are suggesting that this down cycle in oil could be even worse than the 1980s cycle, and as a result, it’s likely that firms will pursue a second round of supply chain cost cuts which will lead to further deflation and job cuts in the next quarter. However, much of that is already baked into stock prices here and so it’s hard to see a lot more damage being done.

Take deep water driller Transocean (RIG), for instance. Deep water rig operators are in a special kind of pain right now, but RIG is already off 65 percent from its stable price levels of a couple of years ago. The stock simply cannot go much lower unless investors decide bankruptcy is imminent. This holds true across most of the energy sector. Related: Midweek Sector Update: Have We Reached A Bottom For Oil Prices?

With that in mind, the takeaways for investors here are two-fold: First, for investors outside the energy sector, the economic data should start to get a little better late this year as the Fed prepares to raise rates. The economy will still have the weight of the oil bust wealth loss hanging on it, but the stimulus effect continues to grow over time, albeit slowly.

For investors in the energy sector, we may be close to a bottom, but the sheer magnitude of wealth loss and capex cuts means that we probably are not going back to normal anytime soon. The last comparable bust of this level was the Tech Bubble of the last 1990s and that took nearly 15 years to fully reverse and for the market to return to its pre-crash level. Energy investors must be patient. That’s all they can do.

By Michael McDonald of Oilprice.com

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  • Ross on August 13 2015 said:
    Buddy, one of us needs to get our math straight... your shale indistry has boosted your production by about 4 mbpd. Your rip off Canadians by discounting our oil almost to nothing. Anyway don't get me started...

    Your shale production has caused oil prices to fall from $100 to about $43 per barrel. honestly, if shale and oil sands had never been developed, oil would be around $130-$150 per barrel and OPEC could squeeze us being a total monopoly controller.

    If the US were importing, say 7.3 million barrels per day at $43 per barrel, are you not saving $781.1 billion per day versus $150 oil if paying full market price?

    So from $100 oil standpoint are you not saving about $521 million per day?

    Man, my expensive scientific calculator can't even go that high for a per year basis in savings!

    We all know who really benefits from low oil, it's the USA. and pretty much you folks alone.

    I hope your goverment is doing something constructive with all of the extra money they are saving, beause when the world's economies are destroyed here shortly once oil hits $10 per barrel, there will be no one to buy your exports, including oil.

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