Low oil prices will hit markets and might cause recession

12 January 2016 11:52 am

Oil prices falling to a 12 year low of just over $31 are likely to have an enormous impact on global markets.

Analysts are warning that prices could now be approaching an inflection point for the US economy. Put simply, many oil producers could be at risk of default. Danske Bank described crude price declines as a “risk to the US economy”. Low prices put pressure on the oil sector. While oil investment makes up just 1pc of US GDP, declines last year dragged GDP down 0.4 percentage points. Analysts at the Danish bank believe weak oil could pull down US GDP again this year.

The big problem is the sovereign wealth funds sitting on trillions of dollars of oil revenue. Some funds are shrinking or are being tapped by governments as oil revenues fall. That’s forcing them to borrow or sell investments. And they have to do it to stay in government.

Adnan Mazarei, deputy director of the International Monetary Fund’s Middle East and Central Asia Department, told The Wall Street Journal hat the worry is sovereign-wealth funds will be forced to sell during a period of already turbulent markets. “A withdrawal of assets by sovereign-wealth funds against the background of liquidity concerns could lead to large price movements,” he says. “Nobody knows how much or when but the concern is there.”

Uncertainty is stoked by the fact that many of the funds don’t disclose their size, holdings or investment strategies, making it hard to gauge what risk, if any, they pose to the global financial system. While others provide clear disclosure and have good governance, sovereign-wealth funds constitute a large blind spot in the markets.

And there lies the problem. Oil-rich Gulf sheikhdoms are being forced to raid their sovereign wealth funds to shore up their budgets. With US crude oil prices falling to $31 per barrel, they have no choice but to reach into these rainy-day savings. For now, they can hold on to some of their trophy assets, like strategic investments in Volkswagen or Barclays. But if crude prices keep tumbling, a fire sale will be hard to avoid. Large chunks of this cash are now being repatriated back to the region to finance widening budget deficits, which this year are expected to be in the region of 13 per cent of GDP in the GCC. But if oil prices fall to $20 a barrel, as Morgan Stanley has warned, the GCC states may have to sell $494 billion worth of booty to make up the budgetary shortfalls based on forecast fiscal costs for their oil production in 2016. This is provided they maintain the lavish rates of public spending that the region’s populations have become accustomed to.

The forced sales will create pressure in the market where the money is (read the US). And that will result in the mother of all corrections. So potentially, we might be looking at a protracted bear market creating another recession.

Scott Minerd, who oversees $240 billion for Guggenheim Partners, expects stocks to fall as much as 15 percent and junk bonds to drop 5 percent as concerns about the energy and commodity sectors ripple through markets. Emerging market equities and currencies will also face downside pressure, he said. “The worst is yet to come,” he told Bloomberg.

So get ready for what's likely to be an oil lead market implosion.