Low oil prices put more money in the pockets of consumers but there is a hidden cost to your savings and ultimately your retirement.
In January I attended a Fund Managers conference in Geneva – clearly not my ‘metier’, but I’d strongly recommend (and this will be the subject of a future post) going to events outside your own industry – you’ll be surprised, always, by what you learn.
Anatole Kaletsky of Gavkal presented a macro view and noted that the decline in oil prices is causing a massive redistribution of petrodollars from producers to consumers. He suggested that the figure is in the order of 2.2 Trillion dollars annually.
This is a big number but the figure is quite easy to get to. Solving for 96 million bbls/day global production, 365 days a year and oil declining from $110/bbl to $35/bbl, one gets to $2.6Tn. Not all of the produced oil is sold, and one can argue about the price end-points used, but as an order or magnitude it looks about right.
The conventional wisdom is that the reduction in the price of crude should give a massive economic stimulus to consumers. So far this stimulus, which has been likened to another round of QE, has not been manifest. One view is that it is a matter of time before consumers recognize the extra cash this is providing, because they need to feel the durability of this rise in disposable income. I suspect that whilst this is true, the actual savings to consumers is significantly less acute. As we all know, the price of petrol (at the pump) is dominated by tax and in addition is slow to react as refiners ensure prices are sticky on the way down.
Roughly half our oil is consumed in transport, and the vast majority of that is in cars. The other ‘half’ is used in the petrochemicals industry – ending up in just about very product you can think of. Sustained low prices should feed through into mainstream goods, but it will take a long time and likely be smothered by other costs and profit margins: I would assume however that the Petrochem industry is making a killing in the meantime…
Let’s look at the redistribution of those petrodollars.
The obvious losers are the Producing countries and NOCs – whose tax revenues have plummeted. Various currencies are under extreme pressure due to the dependency on petrodollars; Venezuela and Nigeria being oft cited examples.
Perhaps less obviously the uber-rich Gulf states have started feeling the pinch. Clearly not time to panic but there is increasing evidence that net-inflows into SWFs is turning into net out-flows as these piggy-banks get raided to maintain social spending beyond the means of pure income. Even Norway is said to be reviewing its position on its Future Generation’s Fund.
Sovereign Wealth Funds
This is important as global equities are in part buoyed by the need of these huge funds to deploy their capital. It is noted that the Norwegian SWF (which was at approx $860 bn) was roughly 60% invested in equities, and that this alone represents some 1.2% of the global equity market. Back calculating from this, you get to roughly $42.5 Tn as the global equity market.
Of the top 10 SWFs, 7 are oil funded (list here). Using rough math, these sum to roughly $7.1 Tn, and lets assume the same 60% split into equities as the Norwegian fund. This would equate to circa 10% of all equities globally being held by the top 7 SWFs. Now I have no idea if these numbers are accurate, but what is quite striking is that these funds have serious clout. If they start exiting positions to prop up their economies, which it seems they have, it would spark a serious market turn.
Pension Funds
The other huge chunk of equity investment comes from developed world pension funds. I found a figure (and can’t find the link.. will edit it in if/when I locate it) that global pension funds manage about $36 Tn. This is spread across multiple asset classes, and a figure of roughly 42% was noted for equities (i.e. $15Tn) – This would equate to roughly 36% of global equities. The dynamics here are quite different, in that the pension funds are not suffering big redemptions as the SWFs are. The problem is that traditionally their equity positions have been long Big Oil, as this was always seen as being decent value with reliable dividends. If you ever wondered why Big Oil cuts Capex and then Opex (i.e. staff) but not dividends – this is why. If one was cynical one could replace “our people our are greatest asset” by “our shareholders are are greatest asset“. Oil stocks have been the Golden Goose for many fund managers, and Big Oil bosses are rewarded on TSR, so need to keep those fund-managers onside – and the best way to do that is to guarantee the dividend.
Now Pension funds invest across all sectors within their equity asset-class subset, but a bit of digging reveals that they hold about 4% of their portfolios in O&G equities which in turn equates to between 1% – 2% of all global equities. As we all know these have taken a beating, and as the big boys start to think about cutting dividends, we can imagine that fund managers will be thinking about greater diversification in there portfolios. Inevitably, if you lose value on your Golden Goose – both in face value and in dividends, your fund will suffer, and you will rotate out in search of better value.
So in short – pension funds are seeing less value from O&G stocks, and, across their broader portfolios all equities will be stressed as vast amounts of SWF money is bing pulled out of the system.
Add on to this the effect of huge job losses in a well paid industry – it is speculated that the lack of economic stimulus in the USA from lower fuel costs is partly explained by the economic slump caused by low oil prices across huge areas of Texas up to North Dakota… And reductions in tax revenues in even modest producers such as the UK, and you can start to see a pattern emerging.
This is even becoming manifest in London house prices as the luxury end of the market (in part fuelled by petrodollars) is getting hit. I would venture that this should flow into ordinary housing prices also. As I discussed in a post on the (non-existent) UK SWF, the UK housing bubble of the past 30 years has been in part driven by North Sea oil tax revenues being handed back as tax-breaks for the middle class. The oil is almost gone and guess what? taxes are being tightened across the middle-classes on a systematic basis. More tax means less disposable income, so less money to throw into an illiquid asset. If prices stagnate or fall, the desire to gear up to the max to up-grade will evaporate as fast as the morning mist.
Deflation – and what comes next
Now I am really getting out of my depth here – but with sustained low oil prices impacting the global equity markets (and probably the global bond markets to a similar extent), there is a strong argument that we could be entering into a period of deflation, or exacerbating an existing neo-deflationary position. The current world economy is stuttering with little growth, low oil prices should be acting as a stimulus, but aren’t. If deflation sets in there are (to paraphrase Marin Katusa) historically two outcomes – either printing money, which, is already being tried by all major players – or war.
Here’s to hoping for a rebound in oil prices.