Is there a downside to plunging oil prices?

If you’ve been listening to the reporting of financial or political pundits, falling oil prices have typically been touted as a ‘major tax cut’ for consumers!

They speak of the fact that the drop in the price of a barrel of oil (WTI currently in the low $60/barrel range) puts money into the consumers pocket that they will spend.

They point out that this is particularly useful now during the holiday shopping season.

From the WSJ, ‘…The decline in gas prices over the last six months is equivalent to a $75 billion tax cut in the U.S., said economists at Goldman Sachs…’

And, ‘“The benefit to the economy is quite significant,” said Joseph Carson, economist at Alliance Bernstein. That windfall also accrues over time.“It’s accumulating every one or two weeks that you go to the pump.” he said.’

But beyond the fact that the drop in consumer spending on gas at the pump and on oil to heat houses could result in a spike in consumer spending on ‘stuff’ during the holiday season and beyond, is there any potential downside to the sharp drop in oil prices?

A darker side to falling oil prices?

Perhaps there is and, for investors and non-investors alike, these pitfalls should at the very least be recognized.

Here are three that have the potential to become problematical in terms of geopolitics, the financial markets and possibly even the financial system as a whole.

Russia and falling oil prices – For Russia, crude oil represents approximately 70% of its exports.

With the plunge in prices that country’s economy is in or close to recession, unemployment is rising, the ruble is setting new lows against the dollar and the D-word, default, is being bandied about for the first time in a long time.

Add to the mix the fact that Russia’s takeover of Crimea was accomplished with little to no resistance from any international powers, indicating that if his back is pushed against the wall economically there is no telling what Vladimir Putin might be willing to do militarily!

High Yield Energy Sector – Representing about 17% of the high yield bond market, energy company bonds have been under a great deal of pressure recently as the perceived and actual default risk has increased.

To many of the firms making markets in these bonds the selloff represents a buying opportunity, but investors need to approach the market cautiously, with buy, hold and sell decisions made carefully.

‘During any protracted downturn, the fate of speculative-grade companies often comes down to a question of leverage—how much debt a company has relative to earnings, and how soon that debt needs to be paid back or refinanced. By now, companies have had several years of extraordinarily low borrowing rates to refinance older debt with new, cheaper, longer-dated debt.‘ (Source)

Derivatives – These are complex financial instruments created in the ‘lab’ by quants from schools like MIT, that exist as a contract between two parties over the price moves of some financial instrument or commodity and that can serve either as a hedge or a bet.

When prices of that instrument are stable or move within reasonable boundaries there are no great issues but, when severe and quick price moves occur such as we have recently experienced in the crude oil market (or mortgage-backed securities in 2007-2008), problems stemming from counterparty risk can present themselves.

Counterparty risk is defined as , ‘The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract.’ (Source)

While we don’t know the exact dollar amount of derivatives contracts that exist or how much of those are based on crude oil, this is what we do know as reported byReuters:

‘Last year, the top ten regional banks active in the space together held an average of $23 billion in commodity derivatives contracts on their books, up nearly 50 percent from their holdings in 2009, according to a Reuters analysis of quarterly regulatory data from Thomson Reuters Bank Insight.

This is still miniscule relative to the $3.9 trillion in commodity derivatives that the top six Wall Street banks still controlled, according to the data, though that sum has barely risen over four years.‘

So if derivatives are a zero sum-game meaning that what one side of the transaction makes the other side will lose, crude oil taking a $40 plunge means that there are some huge losses on the books out there.

We just don’t know whose!

One day these losses will likely have to be realized with unknown financial or ‘unintended’ consequences occurring as a result.

And what will occur if the losing side of a transaction, possibly some of the ‘Too Big To Fail’ institutions, had to actually recognize these trades on their books using mark-to-market?

Mark-to market? That’s a story for another day!

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Written by Michael Haltman, President of Hallmark Abstract Service, New York.

HAS is a provider of title insurance in New York State for residential and commercial real estate transactions specializing in the areas of New York City, Long Island and Westchester.

For anyone either buying a property or refinancing, remember that although your attorney will likely recommend a title insurance provider, you always have the right to choose your own title company (click here to learn more)!

If you have any questions you can reach Michael by email at mhaltman@hallmarkabstractllc.com.