Unintended Consequences? How Oil May Determine Our Future

by Kevin D. Freeman on January 23, 2016

 

The consensus thinking had been that lower oil prices would be beneficial for global consumers. Yet, ever since oil prices started falling rapidly, it seems as if things worsened rather than improved. And, when oil prices rebound (as they did yesterday), the stock market rallies. Clearly, there is more at work with oil than what we see on the surface. This blog will explore some of the unexpected consequences of the oil war underway. Some of these may be truly unintended. Others may actually be purposeful. For most people, however, they are unexpected.

The stock market had its worst start to a New Year in history. The reason? A collapse in oil prices and Big Trouble in Big China–two of the major areas we cover regularly in following the global economic war. As a reminder, the drop in oil prices began as an act of economic warfare. This isn’t a guess. It was directly declared before the price drop began in earnest. It is essential to understand that the oil price drop is a supply problem rather than a lack of demand. And, the Saudis are directly responsible for the excess supply, at least relative to their own past behavior. Previously, they had been willing to cut production to maintain oil prices and maximize revenue. After all, wouldn’t it make more sense to produce 8 million barrels at $100 per barrel than 10 million barrels and only receive $50 per barrel? But that’s not the goal.

We are only now beginning to understand the many implications and purposes of the oil price collapse.

As for China, any astute observer realized long ago that things are not as they have seemed. For one thing, the reported Chinese economic statistics have repeatedly been falsified. In addition, the stated drive to join the modern (Western) world has been a subterfuge. In other words, the Chinese miracle has been part mirage and part malevolent misdirection. Regardless of the “why,” however, nearly all observers admit that the turmoil behind the terrible New Year start for stocks has been oil and China. This has proven to be quite a shock for those who assumed that the global economic war could be ignored without consequence. The worst part is that this is just the first of many very serious implications we are facing. And, there are second-order and third-order effects waiting to happen.

The Financial Markets

Oil has proven extremely disruptive to the financial markets. It’s sort of like the collapse in housing prices but in some ways worse because the energy sector is a larger component of economic revenues.

Here are some of the primary points of impact:

  1. Low oil prices have created a lack of confidence in the global economy and thus depressed investors.
  2. Low oil prices have minimized oil exporter revenues forcing the sale of stocks and bonds. This is particularly true for Sovereign Wealth Funds that had once been bloated by high oil prices.
  3. Low oil prices depress capital spending.
  4. Low oil prices will dramatically lower reported corporate earnings which will continue to impact the future.
  5. Low oil prices threaten the high-yield bond market.
  6. Low oil prices can increase bank loan defaults.
  7. Low oil prices spark deflation fears.

The bottom line is that oil prices, at least at current levels have been highly correlated with the financial markets. Some have projected a price drop to as low as $10 per barrel which could spark even more serious market turmoil. This is not lost on those who have the ability to move oil prices. Oil is an economic weapon and has been viewed that way for a long time.

Political Impacts

  1. A collapsing stock market can impact elections. No one knows this better than Senator John McCain who watched helplessly as the 2008 market collapse cost him a shot at the White House:
    “In our daily tracking, we went from three points up to five points down in 24 hours,” the Arizona Republican said of his standing in the polls when markets went into a free-fall in 2008.
  2. Red state / Blue State. Oil production tends to be in Republican states while consumption is concentrated in Democrat states. A much lower oil price will tend to hurt states like Texas, Oklahoma, North Dakota, Alaska, Louisiana, Wyoming, and Montana. But it will benefit California (which produces oil but consumes even more), New York, and Illinois which have been Democrat strongholds.

Stop and think about this for a moment. Changes in oil prices can impact the stock market. That’s a fact. Changes in the stock market have the power to determine elections. We’ve seen that. Changes in oil prices can also alter the relative well-being of Red and Blue states. In other words our political future can be directly impacted by oil politics that are largely controlled by foreign forces. It is a blunt instrument, but under the right circumstances can be very effective.

Geopolitical Impacts

Collapsing oil prices have seriously altered the global political and economic landscape. Seeming stability has given way to mass disruption. Here are just a few of the impacts already developing:

  1. Worsened immigration. We already have a migrant crisis underway. Collapsing commodity prices, especially oil, have made the situation far worse. From Bloomberg:
    As the crash in commodities prices spreads economic woe across the developing world, Europe could face a wave of migration that will eclipse today’s refugee crisis, says Klaus Schwab, executive chairman of the World Economic Forum.“Look how many countries in Africa, for example, depend on the income from oil exports,” Schwab said in an interview ahead of the WEF’s 46th annual meeting, in the Swiss resort of Davos. “Now imagine 1 billion inhabitants, imagine they all move north.”
  2. Russia unhinged. Russia is a major nuclear power. And the Russians have been active in the global economic war underway. Any further collapse in oil prices would be absolutely devastating. The people, however, have been willing to endure extreme economic hardship, blaming the problems on foreign powers. There is a very real risk of a massive crisis and frightening response. Top U.S. defense officials have recently acknowledged the potential threat that Russia poses to Europe and the world.
  3. Sunni/Shia Cold War. Iran and Saudi Arabia appear to be on a collision course and oil is one of the major sources of tension. The Saudis feel that America has abandoned them. Iran continues to shout death to America even if they try to explain it away. Will this leave us without an ally among the Middle East oil producers? American standing in the region has seriously eroded.
  4. Vulnerability to ISIS. ISIS will use the turmoil to further their goals of reestablishing a caliphate. They have targeted the Saudi oil fields. With the Saudi money flow hammered by lower prices, the ability to protect the nation is diminished.
  5. Africa destabilized. The IMF reports that Africa is especially vulnerable to instability from a sustained low oil price.
  6. Emerging Market Currency Crisis. The global currency regime is imploding as emerging market currencies collapse in a deflationary spiral.

Saudi/China Connection

One of the most serious and disconcerting impacts has been a growing partnership between Saudi Arabia and China. The Chinese have undertaken efforts to protect their domestic oil industry while simultaneously courting the Saudis. The two nations are rapidly building economic interdependence. The implications of this one are enormous, especially given China’s stated intent of “de-Americanizing the world,” as well as their rapid and ongoing military buildup.

It is absolutely essential that we understand this. It has been naive to believe that China has simply wanted to westernize and integrate under American global leadership. They are seeking a new world order with China as the dominant leader.

What do we do about it?

The first thing we must do is recognize the global economic war that is already underway. Only then will we be able to develop a coherent long-term strategy of response. Do we protect the domestic shale industry as we would any industry threatened by foreign dumping? Would rebuilding the Saudi alliance help to restore regional stability? Perhaps if the Saudis didn’t see us as giving in to their arch-enemy Iran they might be more willing to help stabilize the oil market. Or, perhaps we should add to the Strategic Petroleum Reserve (SPR) rather than reducing it? At present, we are planning to sell oil from our SPR which seems outright foolish. Hasn’t anyone heard of “buy low, sell high?” The Chinese have and have been buying oil like crazy. Given the reality that energy is an essential component to national security, we should be taking advantage of low prices rather than exacerbating the difficulties caused by them. Regardless, our responsibility is to recognize the economic war underway, consider the serious implications of it, and develop the best possible response. This is a matter of national survival.

Previous post:

Next post: