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A fresh look at the seemingly preposterous notion that cheap oil is somehow harmful

Net-net, an energy glut affords big benefits but the systemic shock, markets, economies and geopolitics, pose plausible threats

Thursday, January 28, 2016 – 11:22 PM by Guest Columnist Brad McMillan
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Brad McMillan: The outcome [for the Middle East] could well resemble that of the Soviet Union, which faced the same problem.

With over two months on supply in storage, the worldwide supply of oil stands at record highs.

Overall, the effects of the resulting low oil prices in the United States have been positive — very positive, in fact. In the much of the rest of the world, this is even more true. China and Europe, for example, import much more energy as a proportion of their economies than we do, and the positive effects have been proportionately greater.

Whatever troubles China and Europe are having, they would be much, much worse with higher oil prices.

For China, for example, the figures from the MIT Observatory of Economic Complexity show that for the most recent available data oil imports were 2.2% of GDP, while in the United State, on a net basis, they were about 1.0%. See: Why the U.S. should follow China in issuing 50-year bonds.

Figures aren’t available for Europe as a whole, but for Germany, its largest economy, oil imports were also around 2.2%. With a more than 50% drop in oil prices, the relative advantage to those economies, over the United States, would be on the order of 0.5% of GDP for both, which is significant.

Clearly, both Europe and China are much more exposed to higher oil prices — and benefit from lower prices. See: Stock market Euro-trashed: What does it mean for your clients’ wealth?

Floor it

We can also run the same calculation with the United States, but a better way to look at it is to consider where the savings from low oil prices might go.

Retail sales and spending growth has been relatively restrained overall, but people tend to bucket spending in their minds, so the most probable place to look for the economic benefits of lower oil costs would be in transportation as the most likely place for people to spend their savings on gasoline — and that is exactly what we have seen.

With annual auto sales close to 18 million for 2015, a 15-year high, consumers have been spending that savings on new cars, buoying the auto industry and the economy as a whole.


There are, however, real costs of cheap oil.

First, and most obvious, here in the West, is the impact on stock markets. Energy companies have seen their revenues, profits, and asset values decimated. See: Why a flat start doesn’t mean a flat finish for the S&P 500.

Excluding energy, U.S. companies haven’t been doing all that badly, but the energy sector’s terrible results have helped take the entire market down. This decline is probably getting close to the end — oil is not going to zero — but it may still continue for several quarters. See: Three ways RIAs can reassure clients when they’re feeling none-too-assured themselves.

Europe and China are in similar positions, with positive effects overall but real damage to energy companies and the markets.

Elsewhere, things are much worse. Commodity-driven economies like Russia and Venezuela are often in the headlines, but Canada and Norway (and even Alaska and other parts of the United States) are also affected. Any economy built on oil extraction is getting hammered. The damage in more developed economies is less than in countries like Russia, but still real.

Upping the stakes

The collapse of the Soviet Union can be attributed, in many ways, to another era of low oil prices combined with stepped-up U.S. defense spending that the U.S.S.R. tried to match.

The context is different now, but the effect could be the same. Much of Russia’s recent international aggression can plausibly be chalked up to an attempt to cover up domestic economic weakness.

Russia isn’t the biggest problem, though. The international damage we should be most concerned about is in the Middle East. Despite everything, Saudi Arabia has been a force for stability there for the past several decades. Low oil prices could make it impossible for the Saudis to keep their own country stable, much less the rest of the region. See: Saudi Arabia-fueled RIA adds an academic to its oil-rich mix.

Saudi Arabia heavily subsidizes its population, spending billions to provide cheap gas, housing, education, and many other things. As a result, its breakeven price is estimated to be north of $100 per barrel. With oil at $30 per barrel, Saudi Arabia has to take about $80 from its reserves, or borrow, to cover its expenditures. Much of the spending is designed to maintain social stability and buy allegiance to the ruling family, and it has worked.

What ifs

Another example is the recent U.S./Iran negotiations. With oil at $100 per barrel, the Iranians could use the money from the agreement to lift their economy. Now the benefit is much less, and so, quite possibly, is their incentive to keep it. The political costs of the agreement in Iran are offset by much smaller economic benefits.

Taking it one step further, would the United States have signed the agreement if Saudi Arabia was still the dominant oil producer? Probably not, or at least we didn’t.

Egypt, the largest population in the area, is poor and has been supported by oil wealth. Without that, and with the recent political turbulence, things could get even worse. The Islamic State, driven by religious fervor rather than cash, is now significantly better positioned to continue to succeed and expand.

Active rebellions in Yemen and elsewhere will be that much more difficult to suppress. Africa, particularly Nigeria, has the same problem.

The underpinnings of the state system in the Middle East have been economic, but that base is eroding even as spending needs increase — and the outcome could well resemble that of the Soviet Union, which faced the same problem.

Sunny prospects

One way is to think of the complex of states in the Middle East as companies. For example, Saudi Arabia might be a large multinational while ISIS is a start-up with a very different business model. In principle, there’s no reason that countries and states should be treated differently than companies; both are simply ways of organizing people through space and time.

This comparison opens up several paths of analysis, which can provide useful insight into what might happen and what it might mean to the United States — mostly good.

The net effects for the U.S. should continue to be positive. By taking control of a key determinant of the world economy, we are much less vulnerable economically and politically. It’s no accident that major oil powers (Venezuela and Russia) have been able to defy the U.S. And it’s no accident that the major problem in the western hemisphere (Cuba) was enabled by these countries.

With the collapse in oil prices, both the internal stability and economic power of these governments are weakening. With Russia and Venezuela, this is a major positive for the U.S. Even with Saudi Arabia, a longtime ally, the shift gives us the opportunity to act more freely than we could have only a couple of years ago.
In short, one of the principal effects of the oil price collapse has been to empower the U.S. while weakening some of its major adversaries.

Even if prices move back up to the $40 to $60 level, where I believe they will settle, the gap between market prices and the prices most states need to maintain their legitimacy will persist. The erosion of their power, and the corresponding boost to the U.S. position, should continue into the indefinite future.

Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.

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