Oil’s global growth dividend
Right now, the global economy is slowing, with problems in Japan, China, Europe and the Emerging Markets. Only North American growth has remained strong as 2015 approaches. The dip in oil prices changes all of that. While a further fall from these levels will reduce capital expenditure and haircut growth in the US, in Europe and Japan, the reduction in oil prices will be a growth dividend that could add as much as 1% to GDP growth. Some thoughts below
First, while this is a mostly bullish post, my immediate concern regarding oil is the ugly outcomes that further declines in oil prices could mean for capital markets. I have focused on the nexus of shale and fracking in the U.S. and the leveraged loan and high yield bond funding markets, writing that the number of ugly scenarios increase rapidly below the $75-80 a barrel level (see here, here and here). Citigroup notes another source of problems via the loss of dollar credit market liquidity due to the decline in petrodollar accumulation. Izabella Kaminska at the FT blogged Citigroup writing the following (emphasis added):
As each day passes, it’s getting increasingly difficult to explain the underperformance of $ credit markets. The simple answer would seem to be that the steady leak wider in spreads is a result of heavy supply and low long-term yields. Yet there’s something lacking about that explanation. While this month’s calendar has been busy, it hasn’t been any busier than November 2012, a period when 30y yields were below 3%. To our minds then, the softness in credit appears just as likely to be the result of deterioration in demand as a case of too much supply. But who then has stopped buying?
One somewhat novel theory is that sharply lower crude prices might have something to do with the change in the technicals. It seems plausible to us that lower crude prices have led to a slower rate of petrodollar accumulation by oil-exporting countries and less recycling of those funds back into global financial markets—amounting to a non-negligible retraction in liquidity.
There’s little doubt the petrodollar bid for fixed income securities has been tremendous during the last five years. The FX reserves of OPEC members have increased nearly 60% since 2009 to more than $1.3tn—a figure that would surpass $2tn if certain non-OPEC members, like Russia, were included. Likewise, sovereign wealth funds that are primarily funded by crude sales have increased nearly 80% over the same time period to more than $4tn (see figure). Taken together, the AUM of petrodollar investors has increased by $2.5tn in the space of 5 years, or roughly $500bn per year.
Yet not surprisingly, the pace of petrodollar accumulation is highly correlated to the price of oil. When Brent and WTI were trading at $110 and $90 respectively, as they were for much of the last three years, sovereign wealth funds were rapidly growing assets. Indeed, we find a strong empirical relationship between the price of oil and sovereign wealth fund AUM (see figure). WTI above $100 has corresponded to AUM growth of +10%, while WTI at current levels suggests a more modest 5% growth rate.
And of course, there is the negative impact of falling oil prices on capital expenditure, which will hit the U.S. harder than expected in my view. I suggest reading John Dizard, who puts this together well.
But then, what about the benefits of a drop in crude oil prices? I think there are many, especially in the eurozone, where growth has been weak. For example, economists at Unicredit project that with oil prices down 30%, the effect for Europe will be like an “economic airbag”, saving the European economy from crashing. They estimate savings for consumers and companies of up to 35 billion euros at present prices. That’s 1% of GDP and will certainly add to consumption demand in Euroland. Unicredit thinks the dividend for Germany could lead to growth of 1.5% in 2015, well ahead of current estimates, due to the 18 billion euro equivalent of a tax cut for oil consumers. Gavyn Davies even makes the case for the fiscal and monetary landscape adding to this tailwind.
My sense here is that the distribution of dividends from the decline in oil prices will be fairly large due to three factors. First, the U.S. as a big shale producer will feel less of an uptick in growth due to the capex and capital market effects. Second, fiscal and monetary stances are diverging in developed economies, with Europe and Japan the most accommodative, China becoming more so, and the UK and the US the least accommodative on the monetary side. The fiscal side is in transition and I don’t have a clear view on what the relative impact will be. Third, the currency wars are in full bloom, with Japan and Europe leading the charge to use the currency as a vehicle for growth. Many are talking about a secular rise in the U.S. dollar.
The first big wildcard in all of this is China because the Chinese would like to boost demand. We see this with their recent rate cut. But the Yuan is tethered to a strong dollar. And this is going to be a drag on Chinese growth. The second wildcard is the U.S> How can the U.S possibly continue a tightening stance in the face of these pressures. The Fed may end up delaying a rate increase indefinitely if growth is impacted negatively by the strong dollar and lost output in the oil sector. Overall then, I expect Europe to get the biggest boost from the decline in oil prices.