Why Cheap Oil is the Most Destabilizing Force in the World Right Now

Boris Schlossberg

Contrary to conventional wisdom, lower oil prices did not yield a massive “consumer tax cut” in advanced economies in 2015, but instead have laid the foundation for an epic crisis in capital markets as we begin the new year.2016 Oil Crises

For many months, most Wall Street strategists, including yours truly, argued that lower oil prices would create a massive consumer dividend of $100 Billion or more; one that would spark spending and grow US GDP by more that 3% in the second half of 2015.

140827134344-bernanke-financial-crisis-1024x576But everyone failed to realize two key factors that blunted much of the positive impact of low oil prices.

One, the consumer in the industrialized world, and especially in the US, was still deleveraging from the 2008 credit crisis; so a large part of the savings went to servicing or retiring debt.

Lower oil prices did spur some spending, especially in the restaurant sector and in the purchase of new cars; but overall, the boost was modest and Retail Sales consistently missed forecasts in the second half of the year.

oil manThe much bigger problem for the US economy was the collapse of the oil drilling sector, as lower oil prices destroyed both conventional players and the new frackers that added so much innovation and supply to the industry. It turned out that the fracking players were one of the clear success stories of the post 2008 US recovery in the industrial sector. So much so, that by 2015, the US achieved something thought to be impossible by most analysts — it came close to ending the era of being a net importer of energy for the first time since 1950’s.

According to the Energy Information Administration’s annual energy outlook, US net energy imports would fall to zero by 2028 under its base case — or in just four years if oil prices or resources sharply exceeded expectations. Yet while such rosy scenarios continue to float out of Washington, the industry is on the verge of bankruptcy.

frackingOil drilling is a very capital intensive business and the combination of falling oil prices and the hike in rates by the Fed, hangs like the sword of Damocles over the whole sector.

Industry analysts are convinced that unless some sort of restructuring takes place, many players will be forced out of business in 2016… putting a massive drag on US manufacturing growth this year.

The weakness is already evident in the ISM reports which show the whole sector in contractionary territory as of November of last year.

Yet all of these problems pale in comparison to the chaos that is brewing in the global economy now. One of the key factors that many investors fail to appreciate, is that 7 out of the top 10 sovereign wealth funds in the world come from petro-based economies. As their income begins to dwindle, the will need to sell assets will become absolute.

Indeed one of the great untold stories of the current bull market, was the recycling of petro-profits into equities, especially as bond yields compressed lower and lower under the zero interest rate policy regime of the G-20 central banks. That virtuous cycle is about to turn very ugly.

nestegg_090706_wmainSovereign wealth funds, which were designed for very long-term investors, may have no choice but to start to liquidate their holdings in order to prop up their failing economies… much like an unemployed worker is forced to raid his 401K or IRA to pay for living expenses.

Nowhere is the situation more critical than in Saudi Arabia which has pursued a near suicidal policy of high output in order to drive US frackers out of business and preserve its share of the energy market. The net result is that the Saudis, which rely on oil revenue for nearly 80% of their state budget, are now running budget deficits of 20% of GDP.

2011-02-25-shutterstock_45597904To put that in perspective, the US at the absolute worst point of the Great Recession of 2008, never ran budget deficits greater than 10% of GDP.

Clearly, such profligacy cannot last, especially in a one asset economy such as Saudi Arabia. To make matters even worse, the Saudi’s are making a conscious decision to choose guns over butter allocating fully 25% of the budget for defense spending, which includes funds for military involvement in neighboring Yemen that shows no signs of being resolved.

Although world’s attention has been focused on the gangland terror tactics of ISIS, the true danger to geopolitical stability this year could be the fraying control of house of Saud over their increasingly unhappy citizenry. It may be inconceivable to imagine political upheaval in the Gulf, the Middle East’s most prosperous region; but we have all seen how quickly events could unravel in that part of the world. That’s why the collapse in the price of oil…which shows no signs of stabilizing so far…may not be the blessing we all thought it would be for the global economy in 2016.

Until next time,

Boris Schlossberg

Mr. Schlossberg is a weekly contributor to CNBC’s Squawk Box and a regular commentator for CNBC Asia and CNBC Europe. His daily currency research is quoted by Reuters, Dow Jones, Bloomberg and Agence France Presse newswires and appears in numerous business publications and newspapers worldwide. Mr. Schlossberg has written articles on trading for SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is the author of Technical Analysis of the Currency Market and Millionaire Traders: How Everyday People Beat Wall Street at its Own Game, both of which are published by Wiley. Boris’ extensive experience in trading and developing momentum based techniques provide the foundation for BKForex’s strategies.