Oils well that ends well (or is it?)
WTF is going on with the Economy? Issue 003
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Hey there, and welcome to our 3rd issue of WTF is going on with the Economy?!
Over the past month or so, there’s been about a decade’s worth of news coming out.
From an economic perspective, lots have happened.
The global stock market collapsed as the Coronavirus spread across the world.
Then, corporate and government debt -- aka loans or bonds -- went into a tailspin as well once investors saw countries putting their economies into lockdown.
These two events within themselves happen only once every five to ten years. Usually, when they do, it's a case of "either/or," so seeing them both go down at the same time was even rarer.
If that wasn’t enough, in late February, major oil producers decided to have a price war.
In summary, Saudi Arabia asked fellow OPEC members (the cartel made up of many oil-producing countries) to cut their output to keep prices stable. At that time, the price of oil was in freefall as the Coronavirus spread around the globe (spoiler alert: it's still crashing).
OPEC, with the blessing of their members, asked Russia -- who is not a member of OPEC -- to also lower production. But President Putin had other plans, rejecting their proposal and exacerbating the collapse.
Why did Russia do this?
The United States is one of the world’s largest oil producers. However, unlike other countries where pumping oil means figuratively putting a straw in the ground, the US must “frack” the oil out. This process is expensive, and many oil companies there borrowed a lot of money to operate.
Oil has to stay above a specific price for fracking to be profitable. Russian leadership decided that, instead of cutting production, they would continue to pump oil, economics be damned. After all, if it took out the US oil industry, Russian production would come out on top once they weathered the storm.
OPEC and Russia subsequently failed to reach an agreement, sending oil prices crashing, right when the global economy started falling apart.
If you think that the timing was awful, you're absolutely right.
Over the past month, OPEC, Russia, and the United States worked to find some sort of consensus to stop the bleeding. Finally, this weekend, many major oil producers agreed to a historic, 10% production cut.
Furthermore, governments around the world are buying extra oil for their strategic reserves (which is like a rainy day fund for domestic emergencies), taking even more off of the market.
Why is this agreement important?
It's tempting to think that low oil prices mean good news. After all, cheap gas puts more cash in the wallet. However, when the cost of gasoline drops too deep, it usually means that demand is weak. When there's little demand for fuel, then it's a bad sign for the economy.
You're probably thinking, "well, duh, the economy is in the toilet right now," and again, you're correct.
So here’s how it will impact us:
Oil companies, especially those in the west, borrowed a lot of money over the past decade. Many of these firms didn't have a high credit rating to begin with but were able to borrow money thanks to a relatively higher price of oil. When the price of oil cratered, the ability of these companies to repay their debt came into serious doubt.
As we wrote in our first issue, central banks stepped up to buy all sorts of bonds in the economy to help slow the collapse and get cash into the market. While oil companies with bad credit were low down on the list, having to bail them out as well would mean less money for everyone else.
Now, by using market forces instead of government bailouts to stabilize the industry, governments can put funds back into supporting individuals and companies shutting due to force majeure.
You could be thinking that these actions only impact the US. For people in Europe and beyond, the benefit might be limited.
It's essential to keep in mind that many pension and insurance funds around the world invest some of their money in oil companies. These businesses depend on the revenue from dividends and loan repayments (also known as coupon payments) to pay people's pensions and insurance claims.
Further, businesses that require oil to operate like transport companies or manufacturers need stable fuel prices to plan their budgets. While they have financial tools to help them, reducing volatility in the oil markets makes it cheaper for them to do so.
That has a knock-on effect, impacting the price of the food and other essential goods we buy. Keeping these prices under control right now helps all of us tremendously.
But is it enough?
Unfortunately, the production cut can only do so much. Decreasing the oil supply buys time for the economy to re-open. If that process takes too long, demand will fall even further, which makes this weekend's agreement ineffective. In this case, oil prices could go under zero (free gas, but a horrible development otherwise!), although we're not quite there yet.
It's also worth noting that the broad global agreement to cut oil production relies on each country acting in good faith. It will only take one bad actor to start pumping to start another price war. Likewise, in countries where the government does not directly control production, only market forces can keep the private sector from abiding by the cuts.
Oil prices continue to be unstable. As of now, that instability has more to do with the current state of the global economy than with too much oil on the market.
There will still be oil companies that fail. That's just economics where better-run companies survive, and others don't.
However, at this point, it's better to let them fail for this reason. Then, governments can say, "Hey, they were going under anyways. There was no point in us wasting our resources on them."
Plus, we haven’t even scratched the surface of the environmental impact of the oil industry. Until mid-February, there was growing investor and consumer demand for a green revolution, so to speak.
Right now, this debate is on the back-burner of the global policy stove. This discourse will no doubt come back when we start planning what the post-COVID world will look like.
Unfortunately, we don't have the answer to these questions.
For now, we're going to have to hold on tight while we slowly return to normalcy.
Until then, at least there's one less crisis to worry about, at least this week.
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