Oil Price Decline: Secondary Effects

The financial world has focused much attention on oil markets in recent weeks, and rightfully so.  Brent crude and WTI prices have fallen nearly 50% since summer.  This afternoon, WTI has closed below $58 per barrel for the first time since May 2009.  Obviously, this has enormous impacts on oil industry equities, not to mention the biggest oil-producing countries around the world, at least in the intermediate term.  Levered oil service and extraction plays have seen 50% plus declines in stock prices.  Russia, Venezuela, and a host of other countries have begun to experience severe macroeconomic and market stress due to the price declines.  Meanwhile, the effects on the rapidly expanding shale play in the US and Canada haven’t become fully apparent yet.  It’s safe to say, though, that these price declines will start to severely impact future capital spending in the US and Canadian oil spaces.

Just as importantly, the move in oil is beginning to impact other markets and expectations.  Very quickly, we’ll point out a few instances where the impact of oil’s decline is filtering through global markets.

First, let’s take a look at US high-yield bond markets.  As we pointed out earlier this year, high-yield spreads had narrowed to levels unseen since the pre-2007 crisis days reflecting the general high optimism in global markets and investors search for yield.  Now we’re coming to find out that a solid portion of high-yield issuance in the US was related to the emerging oil boom here.  With oil prices cratering, heavily levered oil-related companies are finding their margin for error in terms of debt service rapidly eroding.  This is beginning to influence overall yields and yield spreads relative to Treasuries.  As you can see below, since oil started declining this past summer, yield spreads relative to Treasuries have jumped approximately 200 basis points.  The absolute yield as represented by the Bloomberg High Yield has jumped by nearly 150 basis points over that time period.  While the spread relative to Treasuries is certainly nowhere near the levels associated with crisis (look at the spike in ‘08/’09), there’s been a quick resetting of expectations in the high yield market in line with oil’s declines.

Next, let’s take a look at market inflation expectations globally (below).  Global central banks now have quite a dilemma on their hands, especially the Federal Reserve and the European Central Bank.  Not too dissimilar to the oil spike in ‘07/’08 sowing confusion among central bankers as to the true path of inflation, central bankers now have some tough decisions to make on future policy as expectations for inflation in the US and Europe have dropped dramatically in line with the collapse in oil.  In the US, for instance, QE3 has been effectively wrapped up, economic data has looked strong, and Federal Reserve officials are talking potential rate hikes by mid-2015.  Meanwhile, 10-Year US Treasury yields are hurtling back towards the 2% level and inflation expectations 5 and 10 years forward are falling back to levels last seen during the crisis.  In Europe, persistent economic weakness has pressured price levels for the past few years; even without the new oil price variable, it’s clear that Europe is treading very close to outright deflation, a strongly negative situation from an economic perspective.  Now with oil falling, inflation expectations have accelerated to the downside, perhaps adding to the urgency of the situation.  Accordingly, Mario Draghi and his colleagues at the ECB are mulling much more forceful action, German reluctance be damned.  How do central bankers incorporate oil’s price influence on overall inflation/deflation?  Remember, in the US pre-crisis, the Fed erred by letting commodity price inflation hold them back from acting more forcefully sooner to counter the growing economic problems.  In this case, does a depressed oil price and headline inflation number keep the Fed from acting quickly enough to address a rapidly improving labor market?  Draghi’s situation is a bit more clear cut—core inflation is on a harrowing downward trajectory too--but these new variables certainly make discussions among numerous stakeholders much more difficult.  

Europe 5-Year, 5-Year EUR Inflation Swap Rate (Future Inflation Expectation)

Source: Bloomberg

Again, we see a situation where action in one market begins exerting significant influence on situations elsewhere, and more rapidly than investors and policymakers are prepared to react.  Oil’s price declines are good for many of the world’s consumers, of course, but they create numerous complications for investors and policymakers across asset classes in many of the developed countries.