There has only been one other time in history when the price of oil has fallen more than $50 in six months– it happened in 2008. And it was only months before this country had the worst economic meltdown since the Great Depression.
Since June of last year, the price of oil has fallen from $105 a barrel to less than $50 and it continues to drop each day. Compare that to June of 2008 where the price of oil was hovering around $144 before it dropped like a rock to $43.58 in February of 2009.
The falling price of oil in ’08 was generally attributed to declining consumption as a result of the global recession.
But things are different this time around. And now, we are poised for an even greater economic collapse, due to a few different factors.
It’s important to note that this year, the price of oil isn’t dropping because of declining global consumption. It’s because there is too much supply. In the past 2 years there has been a shale oil boom in the U.S., going from 0.5% of global production to 3.7%. Normally in a situation like this, OPEC would cut production to stabilize the price. But in a recent interview, the Saudi Oil Minister said there are no plans to alter current production rates. Right now, the country sits on more than $800 billion in currency reserves and can easily weather the lower prices for months or even years.
No one is saying why, but many believe the reason the price keeps dropping is because OPEC is intentionally pushing the price of oil down. Why would they want to keep production at its current levels and continue lowering the price of oil?
Well, currently there are two debates over the reason behind the recent declines. One school of thought is that OPEC has secretly aligned with the U.S. to wage an economic war against Russia. If true, it seems to be working.
The declining oil prices and increased NATO sanctions over the conflict in Ukraine have sent the ruble into freefall and Russian citizens have been frantic to do something about the declining value of their currency. IKEA and Jaguar in Moscow sold out of everything in the week following the biggest drop as Russians desperately tried to put their money into something tangible and of value before it became worthless.
The other theory behind OPEC’s efforts to keep the price of oil down is that they were feeling the impact of recent increases in cheap U.S. shale oil production and are lowering the price to hurt American fracking companies. Whether true or not, it is certainly happening.
The break-even price for shale field drilling is $58 a barrel. At current prices, these companies are having to shutter operations and cut back on drilling for the first time ever. New drilling operations fell by 40% in November.
Many believe that any impact to the fracking industry will only be temporary. That’s because new shale wells can be brought online in a matter of weeks, so once prices return to normal, those companies still standing will go back to pumping.
But even when the shale boom resumes, it will be brief and OPEC knows this. Shale wells decline 60 to 70% in the first year and typically dry out only a year or two later. If OPEC isn’t afraid of the shale boom, that gives more weight to the theory they have aligned with the U.S. to hurt Russia.
Unfortunately, there have been unintended consequences to the lower prices, one of which is job losses. This week, US Steel announced it was laying off nearly 800 workers as a result of low gas prices and Texas lost 2,300 jobs in the petroleum and natural gas industry in the month of November.
But there is another more serious consequence that could result from lower oil prices. Not only do these lower prices hurt Russia, they are also hurting American investors. And if the problem gets much worse, it could cause significant damage to major banks.
In 2008, the Great Recession was the result of the too-big-to-fail banks that had been gambling with toxic assets and mortgage-backed securities. They had offered too many sub-prime home loans, the market became flooded, the bubble burst, and people defaulted. Confidence in the banks was shaken. It sent tidal waves throughout the global economy and the major banks had to be bailed out or the entire country could have collapsed.
In 2015, we are facing a different economic bubble. Since the crisis in 2008, the big banks have drastically increased their derivatives purchases. The top 25 banks in the U.S. hold nearly 240 trillion dollars in derivatives. It is not known what portion of these are oil derivatives.
Oil futures purchased earlier in the year hinge on it trading at more than $80 per barrel. With a more than 50% decline in the value, the losses on these derivatives contracts are going to hurt many individual investor portfolios.
What is even more troubling is the fact that 20% of global investment in oil production has been put into shale companies. If these companies fail, not only will it lead to further job losses, it could create a credit crunch and send shockwaves throughout global markets.
If the U.S. does have a secret agreement with OPEC, it may be possible that they can lift prices if the situation in the U.S. gets too dire.
But by then, it could be too late. The Federal Reserve recently ended its program of Quantitative Easing and it’s not yet known if it was effective. Similar efforts in Japan drove the country back into a recession. Billions of freshly-printed dollars were pumped into the economy to stimulate lending but the banks haven’t been as willing to offer loans as they were in 2008. Instead, they have invested that money into stocks and derivatives, giving many Americans a false sense of prosperity. They see the value of their portfolios going up and they think the economy is doing well. But the reality is, the markets are over-inflated and due for a correction.
If the price of oil continues to fall, the value of the derivatives held by these banks will continue to fall as well. This will create a massive credit crunch that hurts asset managers and retirement portfolios.
Since the recession in 2008, the major banks have grown in size by nearly 40% and increased their derivatives holdings by trillions. The top five banks in the U.S. hold 42% of the loans. Many experts say that now they are no longer too big to fail, but too big to bail.
The health of the market and the value of the U.S. dollar is dependent on the perception of the United States’ ability to repay its debts. It is based on trust. If that trust is broken, the value of the dollar could fall just like the ruble. Are you going to rush to IKEA to buy furniture?