"Kee" Points with Jim Kee, Ph.D.

Well, it appears that for now the price of oil has become the official barometer of global risk/instability as far as equity markets are concerned. That’s always been true to some extent, but usually in the context of higher, not lower, oil prices as a measure of geopolitical risks. Just eyeballing the recent data it looks like $40 has indeed been the trigger point. Last August, when oil first dropped below $40 a barrel was when we had the 3rd quarter stock market correction. As oil rose back above $40, the market came back and reversed the loss. But as oil dropped below $40 again the market again started selling off. Looking at longer time frames, the relationship between oil prices and stocks (and the economy) depends upon what is driving the oil price. In the 2000’s when the huge run-up in oil prices was primarily demand driven, it was bullish for stocks as growth (particularly in China) and profitability warranted bidding up the price of oil. On the other hand, when a higher oil price was primarily supply driven (i.e. the oil embargos of the 1970s) the implication for stocks was bearish. I’d characterize the current oil price move as “bullish once stabilization becomes apparent.”


But isn’t the oil price crash like the subprime mortgage decline of 2007-09? No, and in fact it is more closely the opposite! A few words from highly regarded Jefferies strategist David Zervos are helpful here:


“But outside the energy market this is NOTHING like 2008. Every household in America has not taken out a leveraged loan on an energy asset. In fact, nearly every household in America is net short the energy asset. This crash is a huge transfer of wealth away from the levered global energy asset holders to the unlevered average consumer. But because we see the non-linear fire sale and default effects much faster than the linear wealth effects for consumers, it feels pretty messy. There is short-term pain here but a lot of long-term gain.”


What Zervos is saying is that home owners were “long” housing, meaning they were betting that housing values would go up. And they were making a “levered” bet in that they were borrowing money to take this “long” position (taking out a mortgage to go long housing). Leverage is great when assets are increasing in value. For example, suppose you buy a house for $100,000 but only put 20%, or $20,000 down, borrowing the rest (i.e. borrowing $80,000). If you later sell the house for $120,000 you pay back the $80,000 you borrowed and keep the rest, which is $40,000. Since your original investment, the money you put down, was $20,000, you basically doubled your money, from $20,000 to $40,000. Just to make this clear, your house increased in value by 20%, from $100,000 to $120,000, but your $20,000 doubled (i.e. made 100%) because it grew from $20,000 to $40,000. That’s how leverage can make you rich. But suppose that instead of increasing in value by $20,000 the house declined in value by $20,000, or from the original $100,000 to $80,000. If you sell the house for $80,000 you can just pay back the loan and that’s it. The original $20,000 you put down is gone, wiped out. And of course if the house falls below $80,000 then you cannot even pay back the loan if you sell the house, so you are really in financial trouble (underwater). That’s how leverage can ruin you! So now back to oil, the average household has not borrowed money to invest in oil - quite the opposite. The average household has to pay out more money when energy prices rise, and the average household gains when energy prices fall. They are in effect “short” oil and energy. Being short something means you are betting (or benefit) when the price of that something falls, and that’s the case for most US households and businesses with respect to oil.


What’s ahead for Texas? Of course, what’s true for the nation as a whole isn’t true for oil producing states like Texas. The Federal Reserve’s Leading Economic Index (LEI) for Texas has plunged into negative territory, unlike the LEI for the nation as a whole or for similar states that are less energy dependent, like Florida. Texas is also impacted by the strong dollar because it is a big exporter, but it is the fall in energy prices that is really starting to have an impact. And according to Texas A&M’s Real Estate Center (and Jeanie Wyatt about a year and a half ago) the worst for Texas is yet to come. Bryan Pope, the Center’s chief economist, argues that:


“Job losses in the energy sector have not stopped and probably are going to pick up this year…the real impact takes one to three years to hit the marketplace. The initial wave of job losses, including service companies cutting back, has already occurred. The support jobs are next. So the energy sector is going to have a negative effect on employment for at least the next 12 to 18 months!”


Note the “at least”! Houston, for example, though helped by health, construction, refining and petrochemicals (Dallas Fed) has a business-cycle index (calculated by the Dallas Fed) that has already been in negative territory (indicating contraction) off-and-on for the past 12 months. So things should get worse here in Texas, but better nationally.