Oil is too cheap! While some may cheer, in reality this is a concern for the world, not just those of us with direct skin in the game. At least that’s the conclusion I come to when looking at the global tealeaves. Taking one measure, global capital expenditures, we can see indications of how this works. Generally, increasing investment is critical for sustainable growth in global GDP. Standard & Poors prepares a report on yearly global capital expenditures. Their August 2015 report indicated that capital expenditures by the largest 2,000 corporations in the world would decline by 4% in 2016, after falling 1% in 2015, making 2016 the third year in a row for dropping investment. S&P clearly notes the reason: “…this year’s decline would be mainly due to the energy and materials industry, which is set to cut spending by 14 percent as it fights a loss of confidence in commodities amid fears over demand from China.” Or low oil prices as well as low prices for basic materials are causing new investment to dry up.

The S&P report suggested capital spending by the 2000 companies polled peaked at $3.4 trillion in 2013 and subsequently dropped to $3.1 trillion in 2014. Energy and materials companies’ CAPEX reached $1.4 TRILLION dollars in 2013, 41% of total global investment. Yes, trillion! Estimates show this figure has declined by some $400 BILLION by 2015 and is poised to decline from 10-20% AGAIN in 2016. In 2013, North America accounted for 39% of total global energy and materials investments.

This is a global issue, impacting nearly every sector of the economy. Take for example just one region not generally thought of as energy focused. S&P examined capital spending for the largest 20 non-financial corporations in the Asia Pacific region excluding Japan. This group showed combined spending of just over $300 billion of which $146 billion or 48% was energy related. This group’s CAPEX decreased by 6% in 2014 and likely dropped by greater than 10% in 2015 and is poised to drop again in 2016. So nearly 50% of investment by this region’s largest corporations was energy related, and this is falling sharply. If you factor in that a slowdown in energy investment translates into decreased revenue for industrial, IT and other sectors of the economy, the broader impact of what some view as just an energy slowdown becomes obvious. Expanding this thought to the secondary and tertiary impacts, it is not surprising that we have seen a material weakness in macro measures such as negative PMIs and lower GDP outlooks. Throw in China’s industrial overcapacity and highly levered banks, it’s no wonder markets are nervous. QE to infinity!

Since that report, companies have largely announced fourth quarter results and updated capital spending plans.  A group of 47 U.S. centric producers tracked by investment bank Scotia Howard Weil, have reported plans to reduce upstream capital spending from $131 billion in 2015 to $80 billion in 2016, a massive 39% drop. Once again, this incredible change equates to a massive drop in top line revenue for a myriad of other companies, who will then make their own adjustments – thus the ripple effect.

Back to the U.S., many analysts point to the positive impact of lower oil prices bringing lower gasoline prices and thus increasing personal income and disposable cash for consumers. However, many note this “windfall” has not resulted in an increase in consumer spending. In fact, many retailers have guided down 2016 revenue estimates. While it’s true that consumers are receiving the benefit of cheaper prices at the pump, as well as in lower airfares and such, if their employers are seeing slowing sales, layoffs and stagnating wages negate any short-term benefit of low energy prices.

How large is the impact? In the U.S. alone, just looking at gasoline, we used something on the order of 140.5 billion gallons in 2015. Annual U.S. retail gasoline prices as reported by the EIA were $3.44/gallon in 2014, $2.52/gal in 2015 and $1.70 today. Assuming this price for the year, this $1.74/gal drop over two years equates to nearly a $500 billion savings spread over two years. However, the slowing economy and layoffs erase some of the net positive benefit. In 2015, US retail spending ex autos totaled $4.2 trillion. A $250 billion retail gasoline price savings looks like a 6% discount. However consumer spending is some company’s top line revenue.

In a broader context, massive YEARLY investment is required to replace oil production that declines constantly given the nature of reservoir pressures. It is estimated that global oil, condensate and natural gas liquids production, currently 95 million barrel per day, would decline by around 5% per year without incremental investment. That means the industry must develop nearly 5 million barrels per day per year of NEW oil and gas production. (Note: typical shale wells decline 80% in their first year and something on the order of 20% per year for the next three years.) Further, at the beginning of 2015 it was estimated that world was overproducing by 1.5 million barrels per day. In other words, if investment were ZERO, by the end of 2015, the market would be undersupplied by nearly 3.5 million barrels per day. While investment never goes to zero, any pullback in spending threatens a future slice of the required oil supply stack. In other words, a classic commodity boom- bust cycle. In 1998, oil prices reached lows of $14 per barrel. Capital spending slowed and OPEC reduced production. By 1999, oil prices exceeded $20 per barrel and didn’t stop until hitting $147 per barrel in 2008. It is almost certain that changes in supply will exceed that required to balance the market, sparking a corresponding price rally. The availability of abundant shale resources should dampen peak cycle prices. Nevertheless, adding material supplies takes time and capital, it’s literally like steering a $1 trillion super tanker and mistakes are costly. It’s only a matter time before we see the next leg of the oil price cycle. It’s been happening since the dawn of the oil age and it will happen again.

One would be forgiven for reminiscing about that golden age when a certain large organization (cartel) would adjust oil output in order to help balance global oil supply and demand. So, the next time someone cheers low oil prices, just like a good party, beware of the hangover.

Written by: Brad L. Beago, CFA, Agave Investment Partners, LLC