Energy Market Pain: Is It Contagious? – 3/3/16

The US energy market is going to have a rough 2016. Unexpectedly sharp declines in fossil fuel prices caused by Chinese demand uncertainty are set to continue into 2017. Shale drillers, who caused a surge in US oil production and created massive amounts of wealth before oil prices dropped 70% from their peak, are now in danger of drowning in glut of oil they helped cause. As the glut continues, the high-cost producers will struggle to pay interest on their debts with their severely lower revenues putting many at risk of defaulting. So what will happen to the rest of the economy once the waves of default start crashing in?

In the financial sector, bad energy loans will eat into profits and share prices but the effects won’t necessarily devastate lenders. Although big names like Goldman Sachs Group Inc. hold billions in loans to junk-rated firms, their exposure to risky assets isn’t nearly as high as it the subprime crisis. Goldman Sachs explained, as reported by Bloomberg, that the amount of debt outstanding is a fraction of 2007 levels, oil prices have always been volatile so the fall wasn’t totally “unthinkable” or unprepared for, and exposure is far less of an issue since “In 2007… mortgages and mortgage securities comprised 33 percent of all bank loans in the U.S. Today, by contrast, commercial loans to the energy sector are relatively modest at just 2.5 percent of total bank loans”, says Goldman. So maybe proclamations of another financial crisis are a bit premature.

Normally, the decrease in price of such a ubiquitous input as oil would be a boon to the economy as a whole. That low prices usually increase consumer spending and increase profitability for businesses is what makes it strange that some people believe the low prices will have a net negative impact. Some analysts are arguing, since prices have been so low for so long, savings are more likely to increase than consumer spending while the increased defaults by oil and gas companies as well as debt crises in  commodity-exporting nations would tighten up credit lines to business in general. However, just as irrational exuberance can send subprime mortgage-based asset price expectations sky high, irrational pessimism can create just as unreasonable expectations of doomsday scenarios. Rising retail sales, falling unemployment, and other reassuring statistics have led many executives to express their skepticism of a possible recession.

Of course, a fundamentally sound national economy is little consolation for states dragged into recession by the energy sector slump. Alaska, North Dakota, West Virginia, and Wyoming, which all depend heavily on fossil fuel related firms to drive economic activity, are already in a recession.


As seen in the figure, Alaska relied heavily on oil tax revenue while North Dakota and Wyoming will also need to make up for substantial budget shortfalls. Not shown is West Virginia but the state has also suffered greatly from falling fossil fuel demand as exports of coal, its top export commodity, have declined over 40% since 2013. 42 producers of oil and gas in the US have already declared bankruptcy hurting numerous support industries. And things do not seem like they will be getting better soon as banks continue to cut oil-price forecasts to show months or years of low prices to come. Commitments to cutting emissions, increasing renewable energy usage, declining heavy industry capacity in China, democratizing of electric vehicles, and requiring greater fuel efficiency are just some of threats facing those states that depend on fossil fuels besides low prices.

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