Oil price crash could trigger major financial collapse

oil2By Gabriela Motroc

In early January, the price of Brent crude oil dipped below $US50 per barrel for the first time since May 2009. As reported by the BBC, many observers predict that the price of oil will fall even further as North American shale producers keep supplying high quantities of gas and oil. Although market watchers expected the oil-producing group OPEC to cut in oil production to support prices, the cartel that includes Saudi Arabia, Iraq, Iran, Venezuela and other countries failed to agree on how to respond to the impending crisis.

According to observers, the current crash resembles the one that occurred in 2008, when the price of oil crashed by over 40 per cent in less than six months and preceded the financial collapse, which still reverberates in some regions across the world.

Global Research warns that the oil price crash is a sign that economic activity is slowing down and could destabilise financial markets. Energy companies currently account for about 20 per cent of the junk bond market – bonds with higher default risk in relation to investment – grade bonds. A junk bond implosion is generally a sign that a massive stock market crash is about to happen, so keeping an eye on energy junk bonds’ performance could predict a possible collapse. Should junk bonds begin to collapse, Wall Street banks could relive the hardships they experienced in 2008, when Citigroup lost 63 per cent of its value and the Bank of America was cut in half.

Barclays analysts advise that “high yield does provide useful sell signals to equity investors” and, after analysing the past dozen years of data, the warning signal they found was a 30 per cent or greater increase in the spread between Treasuries and junk bonds before a dip, CNN reported.

Dr Kent Moors, Money Morning’s Global Energy Strategist, believes that “long-time oil veterans aren’t worried about falling prices” because “crude has the ability to quickly self-correct”. Prices fell even harder in late November, when OPEC had a meeting in Vienna. Even though it was previously believed that OPEC countries might cut back on their own oil production, the cartel could not agree on how to respond and did nothing to stop the free fall of oil prices. OPEC is currently engaged in a price war with oil producers in the United States and will allow prices to keep falling in the hopes that new drilling projects in the U.S. will prove unprofitable and shut down.

The U.S. now produces more oil than Saudi Arabia and Russia, a boom driven by “tight oil” also known as shale oil, which is produced by fracking. One of its greatest advantages is the fact that wells can be drilled in months, not years. Although it has become cheaper to pump oil out of Kuwait and Saudi Arabia than from shale formations like North Dakota and Texas, as the price keeps falling, some U.S. producers may go out of business. Still, the country’s oil “revolution” has resulted in the creation of millions of jobs since the last recession, so a massive collapse would destabilise the United States’ financial situation yet again.

Also, a plunge in oil prices could have meaningful economic consequences around the world. Russia and Iran are just two examples of countries with economies that walk hand-in-hand with the future of oil price. Oil revenues account for about 45 per cent of Russia’s budget and the spending plans of the country’s government for 2015 had assumed that prices would remain in the $US100 per barrel range. Iran also needs oil prices well above $US100 to balance its budget, especially after Western sanctions have made it harder for the country to export crude.

Although the citizens of the United States might see the glass half full as cheaper oil leads to lower gasoline prices, the oil-producing states – Texas and North Dakota – are likely to experience a drop in both profits and economic activity.

OPEC has failed again to take the matter into its own hands with Saudi Arabia opposing to the idea of cutting production. After the meeting in Vienna, OPEC Secretary-General Abdalla El-Badri said the cartel will produce “30 million barrels a day for the next six months and will watch to see how the market behaves”, Vox reported.

History repeats itself: OPEC’s current lack of action resembles its unwillingness to take decisive action in 2008 until prices dropped below $US40. A similar situation occurred in the mid-1980s, when the cartel did not co-operate when oil prices crashed and reacted only when Saudi Arabia punished the group by flooding the market, Michael Levi, director of the Center for Geoeconomic Studies wrote for The Washington Post.

According to Mr Levi, analysts are already painting a picture of a new “world order” where the U.S. will dominate world markets and low prices will persist in the years to come. Still, the last 10 years have proven that oil prices are rarely stable for long and have taught analysts that political conditions are “critical to their evolution”.


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