Oil Crash Is a Huge Transfer of Wealth

February 2nd, 2016 by

oil rigAs bad as things have gotten on the stock markets in 2016, it has only been the tip of the iceberg when compared to the oil market.

Stocks are undeniably risky business; but even the up-and-down whipsaw of the Dow Jones Industrial Average, the S&P 500, the Nasdaq index, and various other indexes around the world do not compare to the magnitude of volatility for oil prices.

This has caused repercussions throughout the world economy, which we will assess below.

Effect On Producers

The impact of low oil prices on producers should be fairly obvious. It’s bad news!

This goes beyond the fact that these companies receive less money in exchange for each barrel of crude oil they sell. It’s a double-edged sword. Because energy companies must factor in the expected sales price long in advance (usually months in advance), their costs are locked in ahead of time.

For instance, if an oil company planned their operations for selling each barrel for $80, then an opportunity to buy oil at $60 a barrel must have looked like a great deal. If this hypothetical scenario took place last year, that arrangement would have seemed like a steal.

Fast-forward to 2016, when a barrel of oil sells for $30 each. Now the company is not making any profit and is probably losing money on every sale, in fact.

For instance, the giant corporation Exxon Mobile (NYSE:XOM) just reported its worst quarterly earnings since 2002. Also, BP plc (NYSE, LON:BP), the company infamous for the Gulf Oil Spill in 2010, reported its largest-ever annual loss of -$6.5 billion.

As explained below, these losses could also be bad for investors, on a large scale.

Photo: Telegraph (U.K.)

Photo: Telegraph (U.K.)

One would naturally expect oil companies to hold onto their product to reduce supplies to the market, which increases prices. Then they could wait to sell their product at a higher price.

However, this strategy only works if all other oil producers on the market cooperate, which is not the case. The strategy fails because competitors increase their output to steal some market share away from whoever held back supplies.

Effect On Consumers

There is one caveat to the situation introduced above that must be noted: Many consumers are also highly invested in these oil-producing companies or the emerging markets where those companies are located.

Examples of emerging markets that rely heavily on oil exports are Russia, Brazil, and Saudi Arabia. When these countries as a whole are dragged down by weak energy prices, it leads to large losses for investors, who are scattered all over the world.

Nevertheless, the impact of cheap oil for consumers has overall been good. In spite of China’s slowing economy, Chinese companies have booked the most orders for oil in five years. It also means that companies in China are willing to buy oil that must be shipped long distances, such as from Russia and from the North Sea, even though the Middle East is a close neighbor.

Companies that use oil for their energy needs are consumers in this context. Usually, though, we think of individual citizens as consumers.

pumping-gas

Pumping gas

The less money that these average consumers spend on energy needs and putting gas in their vehicles, the more they have left over to spend elsewhere. Many of them are saving the extra money, or using it to pay off debt.

Also, when gas is cheaper, Americans drive their cars more. This might help them conduct more business across greater distances.

According to the Bank of America, the losses for producers are ultimately gains for consumers, translating to a whopping $3 trillion per year. Bank of America Merrill Lynch’s Francisco Blanch calls it “one of the largest transfers of wealth in human history.”

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.