The Unprecedented Threat of Recession From Low Oil Prices

Many people have a portfolio rich in oil companies stocks, because they viewed them as a safe investment. However, oil prices are now extremely low primarily due to the amount of oil being produced by new extraction techniques such as horizontal drilling and fracking.

These techniques enable the extraction of oil from tar sands that are widespread throughout the world. Smaller companies with less capital can tap into shale, and OPEC is finding it more difficult to control the current oil market.

Many oil companies are currently in trouble due to the remarkably low oil prices. According to the Wall Street Journal, “earnings of the energy sector of the S&P 500 have fallen by 76%.” This trend is taking place worldwide and causing turmoil in the financial markets. Over the past quarter, earnings for companies in all sectors have also been reduced. This is bad news, since such an earnings rollover has preceded every recession in a generation.

Historically, rising oil prices caused three previous recessions: those in 1973-75, 1980-81, and 1990-91. Low oil prices have greatly benefitted the markets in the past. With consumers spending less money on gasoline, they have more purchasing power for other goods.

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However, these low oil and gas prices are driving a tightening of lending conditions worldwide. US banks have syndicated leveraged loans for this industry of $276 billion. While 4% were regarded as threatened a year ago, the banking industry considers 15% to be distressed at the moment. A tightening of lending conditions drives recession.

Cutbacks in oil-field expenditures caused a hit to US capital investment, and more cutbacks will come. China’s economy is also suffering from the reduction in oil prices. As oil prices drop, the foreign-exchange value of the US dollar surges. This surge has left China’s currency grossly uncompetitive with the yen and the euro, leading China to devalue its currency. This devaluation creates strains through emerging economies and subsequent deep uncertainty through all global supply chains.

The Wall Street Journal states that perhaps no single one of these stressed would be enough to trigger a global recession. However, the journal points out that recession is often “a death by a thousand cuts, not a single blow” and that the reverse oil-shock made a lot of cuts.

The world’s economy is in unchartered territory, since there has never been a recession due to low oil prices. However, there is cause for optimism, since these low oil prices make the global consumer highly resilient and could buffer the recession’s duration and severity.