Oil's in a Bear Market, and Stocks Will Soon Follow
(Bloomberg View) -- Saudi Arabia's King Salman recently named his son, Mohammed bin Salman, as his successor. The 31-year-old crown prince plans to modernize the kingdom with his "Vision 2030" economic overhaul aimed at weaning Saudi Arabia off oil via increased private sector activity and foreign investment. His icon-breaking plan is obviously a reaction to the collapse in crude oil prices.
It’s badly needed. Almost 80 percent of government revenue comes from oil money. Saudis enjoy a comfortable lifestyle, supported by oil revenues. Two-thirds work for government-related entities, with many in no-show jobs. The youth population is mushrooming, with 45 percent of the total under the age of 25, and the unemployment rate for those between 15 and 24 is 31 percent. GDP has been declining since 2014.
Weak crude oil prices also threaten the crown prince’s plan to raise $2 trillion through Saudi Aramco’s IPO. The Saudis assume $60 per barrel for Brent crude in their Aramco calculations versus about $45 today. And the proxy wars with arch-rival Iran in Yemen and Syria are very expensive and never-ending, so with weak oil prices, the kingdom has been forced to borrow heavily from overseas.
Even if Mohammed bin Salman’s plan succeeds, it may be too late, with further oil price declines in the cards and the accompanying negative effects on U.S. stocks. Here’s why:
Cartels, including OPEC, only exist to keep prices above equilibrium, which encourages cheating as members exceed their allotted output and other producers take advantage of inflated prices. In the decade to November 2014, the cartel’s output was essentially flat while all the growth was mostly enjoyed by Russia, American frackers and Canadian oil sands producers.
That's when restraints were abandoned and output hyped from 30 million barrels a day to almost 34 million. The Saudis and the other Persian Gulf producers with sizable financial resources embarked on a game of chicken, figuring they could stand lower prices longer than their competitors and force other major producers to slash output, especially American frackers. But the number of drilling rigs that are working in the U.S. is rising rapidly after a huge drop, as is output per working rig.
Globally, price-depressing stockpiles remain high, and OPEC production cuts have failed to reduce them, mainly due to the resilience and ingenuity of American frackers. With the decision last November to reduce output by 1.8 million barrels per day, OPEC and its allies have lost the game of chicken.
My earlier forecast of a bottom oil price of $10 to $20 per barrel -- the marginal cost of production in efficient locales -- still seems valid. A drop to that level would be a financial shock reminiscent of the dot-com collapse in the late 1990s that precipitated the 2001 recession and the subprime mortgage debacle in the mid-2000s that touched off the 2007-2009 Great Recession.
Of course, prices would rebound after excess energy production was squeezed out. But, with productivity in the energy sector leaping, especially among American frackers, the equilibrium price of oil might be in the $40 per barrel range, well below the price assumed when many earlier energy investments were made.
America is rapidly reducing its dependence on energy imports but, still, 40 percent of crude oil consumed in the U.S. is imported. So, declining oil prices are beneficial to the U.S. economy as the tax paid to foreign producers is cut. It gives consumers more spending power as gasoline prices fall, and reduces the cost of businesses’ energy imports.
Consequently, you’d expect falling crude oil prices to be associated with rising equity values. But not so! The correlation between West Texas Intermediate crude oil prices and the S&P 500 index since November 2014, when OPEC declined to cut production, has averaged a positive 27 percent even though in the short run, since Feb. 23, crude has dropped 21 percent as the S&P 500 inched up 3.5 percent. In other words, the S&P 500 tends to rise with climbing oil prices and fall when crude declines.
This, in part, is due to the energy sector’s portion of the total index. But with the weakness of energy stocks in recent years, that share has dropped to 6 percent of the total, near a 27-year low and down from 16 percent in 2008.
But when we throw out the energy sector, the remainder of the S&P 500 is still positively correlated with crude oil, with an average 18 percent correlation. This implies that the beneficial economic implications of lower crude oil costs are swamped by negative factors, probably the high financial leverage of many energy companies. After the dozens of bankruptcies during the earlier nosedive in oil prices, investors worry that energy companies’ financial woes could spread throughout the business sector.
Yields on junk-rated energy bond yields are already jumping and the selloff may spread to the rest of the high-yield market. If crude continues to tumble, financial worries will no doubt magnify, and the result could be the shock I’ve been looking for that would end the long bull market in stocks and precipitate a recession.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.”
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