Energy Sector Risk and Loss – 1/15/16

The prolonged slump in oil prices is resulting in increasingly painful losses for the energy sector of most countries as energy-based junk bonds face risk premiums hit 3-year highs. As investors seek to offload these riskier assets and debt markets tighten up, fewer companies will be able to raise the capital needed to survive the low commodity prices and stave off bankruptcy.

A recession in the US is unlikely even with the slowdown in China and crashing commodity prices. Although US commodity companies and trade have taken hits in recent times as evidenced by large job losses in durable-goods makers, miners, and fossil fuel based energy companies, the US is much better prepared to deal with low commodity prices and a weak energy sector. The reason for this is that the US is much less dependent on industry and international trade. It is diversified enough in its resources and job markets that companies owe much less of their incomes to foreign sources. With over 100 million people in the service industry and most new jobs coming from domestically focused industries like education, health, and business services, the US is more likely to benefit from lower prices and the return of capital from commodity dependent emerging-markets. Even in energy, the US has its bets hedged with booms in both shale-oil and renewables. Renewables surprised many in 2015 by attracting billions in investment and creating hundreds of thousands of jobs in spite of low prices of fossil fuel competitors while the shale-oil boom will regain momentum as soon as 2017 if oil prices recover as predicted.

As a country focusing more on capital and technology intensive projects, the US is better insulated from downturns in commodity prices than most. Countries like Russia and Saudi Arabia may have benefited more from high oil prices but now we are seeing just how devastating their reliance on their respective energy sectors can be.

Russian budget headaches are set to turn into migraines if declines in oil prices reach the $20 some analysts predict. Working from a budget originally based on oil averaging at $50 a barrel for 2016 is looking less and less feasible, and with oil and natural gas revenue accounting for half of total government income, the government has no choice but to cut spending and burn through reserves. The cuts will exclude military and social services as the government continues to flex its military muscle with a bombing campaign in Syria.

Meanwhile, nations like Australia and Japan that relied heavily on China’s continued growth to boost their own economies are finding a major customer’s problems are quickly becoming theirs as well. After years of propping up growth using infrastructure projects and heavy interventionism, the Chinese government struggling to maintain industries riddled with inefficiencies stemming from overcapacity and state mandates. Until China regains its footing, the nations that provided the raw materials for the Chinese ascension will have to find new customers.

If Saudi Arabia is set to experience a bumpy 2016, then what about the next 5 years? The next decade? The country sits on one of the largest and cheapest to access reserves in the world, reserves that have made it a wealthy, influential nation by their being invaluable to the world’s oil driven economies. But what happens when those reserves start to lose the value, not just because a fight for market share happened to coincide with falling demand, but because a major consumer like the US has invented ways to reduce demand permanently to cut costs or reduce emissions or avoid dependence on foreign oil. Fuel efficiency standards are already being pushed heavily as environmental concerns are being taken more seriously by all nations. Autonomous and electric cars are set to roll out from major auto companies like Ford. That even China accepted the necessity of climate talks and air pollution reduction should say something about the mood.

So what will Saudi Arabia do? Or rather what is it doing?

The country has long been hedging its bets against the eventual fall of oil. Its leaders have built infrastructure using oil revenues in hopes that the cities it can build now will help it adjust when oil stops being the golden crutch that so many countries rely on. The IPO of Saudi Arabian Oil Co. may just be another move to hedge against hard fall as it would give the country a chance to capitalize on the reserves while they are still worth trillions. Any oil left in the ground when the oil age ends will be worth only a fraction of today’s value. By letting other investors take a stake in the company, the Saudi government can free up capital to invest in more sustainable industries. Besides oil, the country is also abundant in sunlight and the country is already set to make large investments in solar energy as costs of solar systems are fall dramatically… so long as it does not threaten the primary market for Saudi oil – transportation fuel.

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