Oil plummet to put brakes on wages

THE current depressed oil market that could last for a "short-lived" 2-3 years could put the brakes on the US oil and gas market's constantly rising wages, Sprott US Holdings chairman Rick Rule said.
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Rule said basic market mechanisms would ensure things will balance out, yet the irony was that in the last three or four years, the only private sector in the US where wages and salaries for the average American worker have been rapidly rising was the oil and gas sector.

"The wage pressure in the oil and gas sector is probably going to come off as a consequence of lower prices," Rule said.

He said while there was a chance that the collapse in oil from 1985-1987 then again from 2007-2009 which showed a 70% sell-off in the price of oil could occur again in terms of percentages, more important was what was causing the price plummet.

"It's important to talk about what you expect with regards to the duration and extent of the sell-off. A lot of people point to increased American supply but I think that mischaracterises the nature of the sell-off. I think it's demand-related," he said.

"If the nascent recovery that appears to be occurring in the US continues, then this sell-off in energy could be remarkably short-lived. Notice that I said ‘if.' I'm not an economist.

"The truth is I have absolutely no idea what will be the extent or duration of the sell-off. I only know that markets work. The cure for high prices [despite Washington's consternation last year over high fuel prices], is precisely that - high prices. The best they can possibly do is nothing. The cure for low prices, simultaneously, is low prices. The truth is that low energy prices will constrain supply over time and stimulate demand.

"Markets work, but they're very messy and unpleasant if you get caught on the wrong side of them. That's the truism that all of our readers need to remember."

Sprott US Holdings has estimated that over $US1 trillion worth of energy-related debt may now come into question with the lower oil prices.

Rule said the net present value of production at $100/barrel is much higher than the net present value of that same production at $60/bbl.

"So borrowing bases will be reduced as a result of write-downs over the next two to three years," he said.

"In some of the credit arrangements, what was an interest-only evergreen facility will become a four or five-year term facility with no room for additional credit. In fact, the requirement to pay down the existing credit may mean some companies will have no expansion capital.

"If a company has been drilling shale wells with very high initial production rates but then rapidly declining production, your production and hence your cash flow falls off very, very quickly.

"So this is a situation which, if you're as old as I am, you have observed two or three times before.

"The problem that some of the smaller overleveraged producers will have is that they're going to have to sell some properties in competition with other small producers who are similarly overleveraged in a market that is cash-constrained because there isn't much credit available for acquisitions either."

Rule added that in terms of the solvency of the banking system in general in the US, the decline in energy prices was "a very good thing".

"As painful as it may be for the exploration and production business in the US, it's pretty good for the refining and marketing business," Rule said.

"Their crude costs fall and it's wonderful for energy-intensive businesses like chemical producers, trucking companies, airlines, etc.

"So while on one hand the sell-off weakens the credits behind $1.6 trillion in credit facilities in the US, it probably strengthens another $6 trillion of corporate loans in the US. So on balance, declining energy prices are good."