We did not see oil prices falling to $55 per barrel. What happened? A combination of economic fundamentals and strategic manipulation are at work.
Soft global demand collided with expanding production in the U.S., and made price decline inevitable. OPEC’s (specifically Saudi Arabia’s) expressed intent to “maintain market share” by keeping the oil spigot wide open is a significant factor in the steepness of the decline and the tipping point that no one saw coming. The Saudis have billions in hard currency reserves and low production costs. The onset of the decline in prices coincided with the strengthening of the U.S. dollar in June when the Federal Reserve announced the end of its half-decade long campaign of injecting cash into the economy to prop up prices. Oil prices and the U.S. dollar are inter-related, so a strong U.S. dollar will help to keep oil prices low.
The 50 percent drop in oil prices since the summer peak is steeper than typical. The current situation is unique in that over the past 30 years a dramatic drop in oil would normally be accompanied by a U.S. recession (1987-88, 1990-1993, 2000-2003) or an Asian financial crisis (1996-1998). There is no recession occurring in the U.S., nor is one probable according to the leading indicator inputs. We are sailing in uncharted waters.
The leading indicators ITR Economics tracks are giving no sign that the U.S. will follow other nations into a recession in 2015. The ITR Leading Indicator, U.S. Leading Indicator, Purchasing Managers Index and non-defense capital goods new orders all remain above year-ago levels. U.S. corporations are cash rich and making money (financial companies being a notable exception). Companies are buying equipment, improving efficiencies, and investing in information technology.
Congress approved the tax extenders for 2015, including the accelerated depreciation allowance. Employment is rising. And the record-breaking stock market run is providing many Americans with a greater sense of security. Our self-sufficiency and financial health serves us well right now. ITR Economics’ outlook has not changed for 2015 or 2016. We expect growth to continue, but at a slightly milder pace in 2015.
Ongoing economic growth is showing itself in capacity utilization rates, with many industries above their 20-year averages. The slack created by the Great Recession has either been put to work or been removed from the books. This is a reflection of an expanding economic environment. The oil price decline could soften growth in some sectors/businesses. But whatever downside pressures there may be on industrial production and to a lesser extent on GDP, the upside of increasing consumer and business discretionary income should contribute to a rebalancing of the U.S. economy toward more consumption and service sector activity. So far in this post-recession period, industrial production has been growing appreciably faster than the service sector. We expect some rebalancing in 2015 as consumers take full advantage of low energy costs while the oil and gas extraction (10.1 percent of industrial production in 2011) slows in its rate of growth.
The economies of the globe are not synchronized at the moment, and they won’t be for the coming year. The best opportunities in 2015 will be in North America, which is driving growth for the larger global economy. The U.S. alone accounts for 22.7 percent of global GDP. Add Canada and Mexico, and North America is providing more economic updraft than anywhere else in the world.
Globally speaking, fears that Europe’s decline will pull the U.S. economy into recession are misplaced. The strength of the U.S. dollar combined with weak global economic growth will certainly impact U.S. exporters, but the U.S. is not nearly as dependent on exports for growth as Europe, China, Japan and India.
Europe’s tepid recovery is falling into mild descent. There is growth in some eastern nations, but difficulties linger in the larger western economies. Annual industrial production in Germany is rising, but the pace of growth is slowing. France, Italy and Greece are running below year-earlier levels. The UK is faring better than Germany and France. ITR Economics’ analysis is that the cyclical weakening will last through at least three quarters of 2015 before we see signs of a recovery in the region.
China (GDP ostensibly equaling 12.4 percent of the world’s GDP) is slowing in its ascent, and industrial production is rising at 9.1 percent (annual basis). Japan, the world’s third largest economy, is technically in its fourth recession in six years. Russia’s economic woes are increasing: Interest rates rose to 17 percent, the ruble fell to half the value it had six months ago, world oil prices are below Russian production costs, and sanctions are limiting foreign investment. India’s economy, smaller than Russia’s, is growing at a mild 1.0 percent (industrial production, annual basis).
More on oil price effects
Energy production is 8.0 percent of U.S. GDP and 10.0 percent of U.S. industrial production. The November industrial production data showed both the mining and manufacturing sectors still rising at an accelerating pace, and there is no sign of any fall-off yet. However, we expect the oil price decline to slow industrial production growth in 2015. Our major concern with oil prices is the implication to our energy-related clients, and not as a perceived risk to the general economy at this time.
Among the winners are low to middle income families and those on fixed incomes, for whom cheaper fuel costs have a larger proportionate effect on their disposable income. Retailers should see more cash coming in and healthier bottom lines. Businesses will feel relief from energy prices. Europe’s economy may fear deflation, but this could lift to consumer discretionary income at a much needed time.
The obvious exceptions to the list of winners are those heavily invested in the oil industry and a multitude of upstream small fabricated metal shops, equipment manufacturers, and wholesale distributors. No oil producer likes this price point. Expansion will likely slow in 2015. Those long invested in established oil fields can survive this “fight” at $50 to $55 a barrel, even if it extends through 2015. Late entries to the oil patch will slow their rate of expansion, close or sell. Energy stocks have fallen over 19 percent this year, while the market itself is up over 14 percent. A few oil companies have announced reductions to their capital investments for 2015.
Consider the impact of low oil prices on Russia and ISIS. Already under severe economic sanctions, Russia and Iran are running out of options for their stagnant economies. Russia’s foreign direct investment is down $103 billion from a year ago and capital improvements are wobbling. Russia’s interest rate spike has so far proven ineffectual at stemming the ruble’s rout, and Russia’s central bank has been spending down its hard currency reserves without success. There is some good news from low oil prices in that ISIS fueled its brutal killing spree by selling oil on the black market, when prices were $90 to $110 per barrel. The U.S. and allies have closed supply routes and oil prices may starve the ISIS war machine.
The big question is how long oil prices will remain this low. There is no clear precedent for the extent of this decline. History suggests that oil prices will remain low into at least the third quarter of 2015. Though oil prices may dip into the mid $40 per barrel, we think prices are more likely to drift around the mid $50s for the first three quarters of 2015 and head higher as we end 2015. This is based on the ongoing strength of the U.S. dollar, the leading indicator trends, and our analysis of historic trend characteristics.
It is important to note that we expect the U.S. economy and global economies to move onto the upside of the next business cycle during 2016, which will shift demand in favor of a price rise. What is happening today with oil prices is not the crippling oil embargos of the 1970s. The U.S. economy is expanding and has an abundance of energy resources. Prices could be the timely stimulus enabling a strong U.S. economy to become even stronger. A strong economy and 50 percent decline in energy costs should spur U.S. businesses to invest in upgrading equipment and technology. We think the U.S. in general has more to win than lose in 2015.