Supply Chain Frontiers issue #60
One of the mysteries of the stock market’s decline at the beginning of 2016 is why such a precipitous fall occurred at a time when economies are reaping the benefits of lower energy costs.
As oil prices parachuted to depths not seen since the tech crash of the early 2000s, factories, transportation carriers, and consumers pocketed substantial savings on fuel costs. The plunge in oil prices transfers about $1,500 every year from Saudi Arabia, Russia, Venezuela and other oil producers to the pockets of every US driver. The US economy, which is based in large part on consumer spending, should be soaring, and the market valuation of most firms (sans energy producers) should hit new highs.
Why is this not happening, and why might we be heading for a recession?
Cheap oil causes severe financial difficulties for those countries that are heavily dependent on oil exports. In many of these countries citizens have come to expect government largesse based on high revenues from oil exports. As a result, these governments are unable to reduce their expenditures to offset ballooning budget deficits. Take, for example, Saudi Arabia. In 2015 it ran a budget deficit of $98 billion, and despite its attempt to cut subsidies and other expenses, the shortfall may be even larger in 2016.
Of course, the Saudis have significant financial reserves – about $610 - $630 billion at the beginning of 2016. These reserves have not been parked in money market accounts but have been invested instead in foreign assets, including US and European equities. Now the Saudis have to raise over $8 billion a month to finance the country’s deficit. To do this they must liquidate these investments. Such selling pressure has significant impact on financial markets worldwide.
Let’s assume for the sake of argument that half of Saudi’s reserves is in US equities. This means that some $4 billion worth of “sell” orders have to hit the market every month. Russia, Venezuela, China, Mexico, Brazil, and many other countries share the same predicament and must also raise billions of dollars by liquidating stock holdings. Thus, billions of dollars in sell orders cause the financial market worldwide to contract.
At the same time, the supply of oil keeps growing because oil-dependent countries have no choice but to pump more black gold. Even relatively high-cost fracking producers in the US continue pumping in order to pay down their debts. Add to this the new flow of oil from Iran and the slowdown of the Chinese economy, and the oil over-supply looks like it is here to stay for a long time.
At this point market psychology starts to take effect. As the stock market heads downwards, more investors head to the exit in a rush to lock in the gains of the last few years. Consumers’ 401Ks and other investments decline in value, these consumers become skittish, and start curtailing purchases. Pretty soon every part of the “real” economy starts feeling the pain and we are heading for a recession. The US Federal Reserve’s poorly timed action to raise interest rates adds fuel to the fire.
This self-reinforcing feedback loop of slowing economies keeps driving oil consumption down, thus lowering oil prices even further and forcing oil producers to sell even more equities (now with consumers and fund managers joining them). Stock markets around the world decline and consumers buy less. Cautious retailers slow down ordering, factory production falls below the volumes where operations are efficient, capital investment dries up, companies cut employees, and on it goes.
The worrisome part of this analysis is that most “surprises” in the coming year are likely to be on the down side. Social unrest in oil-producing countries and China, deteriorating relations between the Saudis and Iran, an even more belligerent Russia as the country tries to divert attention from its crumbling economy, a fraying European Union, and irresponsible leadership in the US, are some examples.
It’s possible that we will avoid a full-blown recession this year. However, in a number of ways the quick decline in oil prices is fool’s gold, and at the very least, we are in for a rocky economic ride in 2016.
This article was written by Professor Yossi Sheffi, Director, MIT CTL, and originally published by Linkedin Influencer.