Taking the long view on oil

Last week, in “An Oil Lender’s Take On The Price Drop,” we discussed the impact of the current year’s decline in oil prices on the business economy of Midland, Texas, a city located at the center of the most prolific oil field in the history of the continental U.S. My conversation with banker Ken Burgess surprised me, as I learned that the outlook there remains very positive even after the recent 50% drop in oil prices per barrel.

Clearly there were factors operating this time that have impacted other sectors of the petroleum market differently, thereby focusing the effects of oil prices in the consumers’ minds on gasoline prices.

But what about the implications for the American economy over the next several calendar quarters? 

Happy days are here again?

There is consensus, at least to the regular viewers of CNBC, that the overall impacts of the oil price drop will be clearly beneficial to the consumer. In fact we saw the other day a significant improvement in the index of consumer confidence that was directly attributable to oil price.

Some economists are predicting that for 2015, the average household will save about $550 in gasoline costs. Many are likening this to a “tax cut” and it will no doubt have a beneficial impact on household consumption budgets.

To the extent that oil is a feedstock to the production of a great many materials and products that are components of other manufacturing processes, this will help many sectors of the American economy. Airlines, trucking companies, and all users of oil for transportation purposes have already benefited considerably from the improvement in their cost structures over the last several months.

There are important geopolitical implications too—generally positive, prospectively, for American interests. Since World War II up to and including the current time, the U.S. has been a large net importer of oil. This has had significant negative impact on our international balance of payments. There are also grave potential threats to our interests in circumstances where a significant portion of our oil supply is subject to interruption by foreign powers unfriendly to us or our allies.

Balancing supply and demand—and slowdown

However, the increase in production in the recent past has disturbed the relatively thin balance between supply and demand in world markets. Oil demand normally applies a gentle long term upward bias to prices, as the growth of markets in both developed and undeveloped countries has contributed to increased demand over many decades.

But worldwide demand for oil has not met forecasted expectations for the last several months. This is likely to be the most important point to consider as bankers contemplate the impact of energy prices in our local and regional economies. A significant downturn in oil consumption has portentous implications for overall economic activity worldwide.

In short, global business activity appears to be cooling off.

This seemingly contradicts recent improvements in economic indicia for our domestic economy. The unemployment rate continues to decline and GDP surged for the latest reported period and is strongly positive this year to last.

Is this performance sustainable? 

How much will it influence the Federal Reserve Board of Governors’ implementation of monetary policy? 

Are interest rates likely to increase or remain unchanged in the new year?

What about sectors facing downsides?

It is difficult to underestimate the effects of U.S. shale oil production. The very large and prolific Eagle Ford shale formation in southern Texas came on stream in 2008 when domestic oil production totaled 4.7 million barrels per day. By September of this year, domestic daily production had increased to 8.9 million barrels nationally thanks to Eagle Ford and several other important shale production plays nationally.

However, there will likely be losers in the prospective business and political climate for 2015.  

Consider these possibilities:

• The Keystone pipeline project is subject to cancellation as uneconomic or indefinitely delayed.

• Oil field drilling and service companies will likely reduce employee headcount, perhaps for an extended period.

• Several large banks participating in merger activity lending among oil field players may experience a downgrading of their borrowers’ debt to include mark-to-market accounting treatment on loans they are currently unable to syndicate.

• Community banks located in oil producing markets, although frequently not direct lenders to oil field participants, will experience trade area business slowdowns.

• New oil and gas exploration will likely be curtailed for the duration of the slump at prices less than $60 per barrel.

• State budgets for the fiscal year beginning in July 2015 will experience a direct and immediate drop in severance tax receipts to the extent that producers limit production at current or lower prices.

Long-term, though, supply and demand ebbs and flows with, as noted, an upward bias to price. This is expected to continue well into the future but the zigs and zags in economic performance and the resulting effects on various components and companies are something that we’ll all have to watch carefully.

How ready are banks?

In Midland, based on my conversation with Ken Burgess, reported last week, the banks seem to be ready for what will come in 2015.

But, I wonder: Will the shale oil boom that has been a new experience for many locales find the banks in those areas as able to adjust to different volumes of activity as the experienced Texas banks?

One more time—and for the second time since 2008—we will learn the importance of that C of Credit known as Conditions.

A rising tide lifts all ships—but an ebb tide has the opposite effect. We’ll see in a few months how well positioned the banking industry is to make these almost certain adjustments across a wide range of business activity.