Is the Next Recession on the Way? Here’s Everything You Need to Know About the Market’s Oil Collapse

Given how the first few weeks of January have played out, I feel sorry for anyone who chose as a New Year’s resolution to check their retirement accounts more assiduously. Stocks hit a 15-month low last Friday. Analysts cite a number of factors in the slowdown – China’s economic woes, the strong dollar – but the biggest culprit appears to be the dip in the price of oil, from a high of $100 a barrel in mid-2014 to under $29 a barrel, which is over three times cheaper than the price of the barrel itself. By the way, the Iranian nuclear deal, which will allow the major oil producer to return to global markets, makes future price prospects worse, not better.

At this moment, everyone should repeat to themselves the mantra that the stock market is not the economy, stop checking their portfolios, and get on with their lives. However, the oil price collapse could spill into the real economy, and not in the ways everybody expected when prices began to fall over a year ago.

At that time, as Paul Krugman explained over the weekend, the conventional wisdom held that oil price drops would benefit the U.S. economy on net. The theory goes that reductions in the price of gasoline help consumers, who have a higher propensity to spend money than oil companies and their executives. Consumers would take the windfall savings and cycle it through the economy, increasing growth. Sure, oil companies would feel the pain, but the benefits would spread to many more people. President Obama referred to this in the State of the Union address when he quipped, “Gas under two bucks a gallon ain’t bad, either.”

But this overlooked a couple points. Number one: Over the past several years, fossil fuel production has grown as a share of the U.S. economy. Serious disruptions in price – like the 70 percent drop we’re seeing now – is battering shale producers in North Dakota and Oklahoma as much as traditional oilmen in Texas and Louisiana and Alaska. That includes the fracking boom, which has spread throughout the country.

Moreover, lots of new producers built their businesses on a pile of debt. They had to purchase equipment and fund operations until their exploration hit paydirt. Investors loaned much of this energy-related debt in the form of junk bonds, made attractive because they earned a higher yield than more traditional investments. With interest rates near zero, investors craved higher returns. So they handed out massive amounts of corporate loans to the energy sector and elsewhere. Junk bonds reached $1.7 trillion over the past five years; about 27 percent of this high-yield debt came from oil companies.

This worked out fine, as long as defaults remained low and yields high. But Krugman identifies the problem: Severe price drops have dramatic effects on oil producers, and everyone who profits from the hydrocarbon-based economy. Suddenly, highly leveraged oil companies who set their business models on the expectation of $100 a barrel could not survive with the price below $40. State and national governments dependent on oil tax revenue, from Saudi Arabia to Alaska, needed to patch big holes in their budget. The subsequent cutbacks and bankruptcies and debt writedowns drag on the economy.

And the way in which debt connects the oil industry to the financial system rippled the impact out further. Investors started to flee the junk bond market, to such a degree that some institutions catering to them had to shut down their funds and halt redemptions, preventing clients from quickly pulling their money. High-yield investment managers may not have the cash reserves to deal with a continuing, significant capital flight.

There’s more to this story. A lot of high-yield debt was packaged into collateralized loan obligations (CLOs), resembling the securities composed of mortgage loans during the housing bubble. Other debt went into mutual funds marketed to ordinary investors, not just the big boys. And energy-related junk bonds, the raw material inside these other derivatives and investments, “could be worth close to zero,” according to Gretchen Morgenson at the New York Times.

Precisely how much debt is out there, how much is wrapped up with energy, and how many derivatives magnify the problem isn’t fully known. Most important, who will buy high-yield debt if the sell-off continues? The lack of transparency makes it difficult to price these instruments as they fall. And we really don’t know whether the contagion will spread, constricting not just energy investment but investment in other economic sectors. So far we have indications of a slowdown beyond commodities, but it’s early.

In other words, nobody should predict a recession from this news – the numbers at play are far smaller than the size of the housing bubble, for one thing. But the underlying uncertainty is creating lots of anxious investors. And anxiety can transform into panic, a good characterization of the stock market in the past couple weeks. Is that a leading indicator or a false one? We will surely find out.

Economist Dean Baker, known for his call on the housing bubble, thinks everyone should calm down. The economy is in the same slow growth recovery it’s been in for years, Baker writes, and the market turmoil is localized and shouldn’t have a broad impact. Anyway, consumers do still have that extra money to spend.

I’d be a lot more confident in that pronouncement if the U.S. financial sector didn’t take up so much of our economic activity. The hidden risks through over-reliance on high-yield debt are just starting to reveal themselves. And the system remains too interconnected and untested in whether it’s resilient enough to withstand failure in one area. Financial regulators actually did a good job last year kicking high-yield loans out of the major banks. But some banks remain exposed.

If this is a bigger deal than Baker thinks, it tests the Dodd-Frank law, which maintained the system we already had and attempted to strengthen it, rather than overhauling it by segregating assets. And it also tests the Federal Reserve, which appears committed to regularly raising interest rates, potentially increasing the pain. A related problem is that rates are currently so close to zero that, if we do reach some point of crisis, central banks have little room to influence events unless they act in far more unorthodox ways than they’ve been willing to since 2008.

Finally, it goes without saying that the state of the economy has implications for that little election thing we’ll be doing in about 10 months. It would behoove everyone involved – particularly on the Democratic side – to pay attention to what’s going on, and formulate a response. I hope it won’t be needed, and I hope it’s not too late. But you never know.