Oil prices may be going up, but they can still cause a US recession

It appears oil prices have found the bottom in recent days, with prices recovering from mid-$20-a-barrel lows back into the $33-$34 range.

But according to Jason Schenker, president and chief economist at Prestige Economics, the uptick in oil price isn’t enough to save many oil companies — or the US economy — from disaster.

“Oil prices simply aren’t going to rise fast enough to keep oil and energy companies from defaulting,” Schenker told Business Insider.

“Then there is a real contagion risk to financial companies and from there to the rest of the economy.”

According to Schenker, this means the US economy will dip into a recession either at the end of 2016 or the start of 2017.

Schenker’s logic works a bit like dominoes. First, oil will rise but only to the mid- to upper-$30 a barrel range, which is not enough to keep many US drillers from defaulting on loans. This in turn puts a squeeze on banks’ bottom lines.

And while there has been some pushback on this idea since banks have stronger balance sheets, Schenker said that it wouldn’t take much to change their behaviour.

“It is smaller than housing, so it’s not as bad as some sort of 2008-style collapse,” said Schenker. “But if you’re a bank and you’re losing money on some of your loans, you’re going to tighten lending standards to other corporations.”

It is true that oil and energy loans are not as large as mortgage debt before the Great Recession and banks generally have stronger balance sheets, but to Schenker the impact doesn’t need to be a substantial to push the economy into recession.

By tightening lending standards and restricting credit to corporations, there will be less business spending and eventually layoffs.

“When banks don’t lend, there goes debt-financed capital expenditures and operating expenditures, and you get a slowing or decreasing business growth,” said Schenker. “In this case unemployment would then go up as companies have to cut costs.”

In this scenario, Schenker said, unemployment would tick up a few per cent, to around 6.5% to 7%.

Essentially, in Schenker’s assessment this is similar to the 2000-2001 recession, but with oil companies substituted for the tech industry.

Additionally this sort of small tip into recession makes sense because as Morgan Stanley noted, in the era of low, slow GDP growth, it doesn’t take as much to nudge the economy below the threshold of a recession.

As always, there’s another side to this argument. For one thing, bank executives have played down the importance of oil and gas loans on their balance sheets, and have been prepping for this possible increase in defaults for some time.

Additionally, the labour and consumer side of the picture remains relatively strong despite some recent slipping in headline figures.

To Schenker, however, the negative trickle-down through the labour market and consumer credit channels will infect the stronger these parts of the economy and lead to a “mild recession.”

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