[ Yet another “crash coming soon” post, if it hasn’t happened already (I scheduled this article and others to appear a year or more later, since crashes always take longer to happen than you expect.
Alice Friedemann www.energyskeptic.com author of “When Trucks Stop Running: Energy and the Future of Transportation”, 2015, Springer and “Crunch! Whole Grain Artisan Chips and Crackers”. Podcasts: Practical Prepping, KunstlerCast 253, KunstlerCast278, Peak Prosperity , XX2 report ]
Denning, L. March 30, 2016. The extend-and-pretend oil market. Bloomberg.com
In several recent reports, energy economist Phil Verleger has laid out the unsettling similarities between the U.S. residential construction bubble and the later surge in oil and gas drilling investment.
We’ll still be arguing decades from now about exactly why we collectively went crazy for Floridian sub-divisions and the like, but cheap and plentiful credit was clearly a big factor.
The same goes for the oil and gas boom.
The face value of energy debt as a proportion of the BofA Merrill Lynch High Yield Index has surged from 6% in 1997 to 16% today.
[ My comment: When oil and gas cause the next financial crash, it will not only be “dumb money” middle class Americans who are plowing their money into high-yield bonds and stocks to make back their money from 2008, but also foreign countries who’ve invested $450 billion in debt securities such as Brazil, China, Colombia, Indonesia, Kazakhstan, Kuwait, Malaysia, Mexico, Nigeria, Qatar, Russia, UAE and Venezuela.
Just as the housing bubble relied on faith in U.S. house prices only going up, so investors’ willingness to buy the energy sector’s bonds (and stocks) rested on a couple of intoxicating assumptions: OPEC would backstop prices and China would never falter (so, about that…)
American exploration and production companies weren’t the only ones on a debt-and-drilling binge. Last month in London, Jaime Caruana of the Bank for International Settlements gave a speech on the interplay of “Credit, commodities, and currencies.” He noted that loans and bonds outstanding for the oil and gas industry had almost tripled between 2006 and 2014 to $3 trillion, including a large slug taken on by firms in emerging markets.
Just as the mortgage pile-up transformed the U.S. housing market, so the legacy of the energy sector’s credit craze will live on in several important — and conflicting — ways, for years to come.
One effect Caruana highlighted is how a high debt burden focuses the mind on generating cash flow to meet interest payments. This surely explains at least some of the sheer resilience of not just U.S. but global oil production in the face of low prices. While banks must eventually pull lines of credit from struggling oil producers, they are no doubt loath to take ownership of leases and rigs in a bankruptcy situation, putting off the day of reckoning.
If that prolongs the market’s pain today, though, it also offers some hope for tomorrow. Going back to Verleger’s chart above, he rightly shows that investment in new oil and gas prospects is set to plummet well below what the International Energy Agency says is needed.
Indeed, earlier this month, the IEA’s head of its Oil Industry and Markets division warned that today’s low oil prices are setting up a potential supply shock in the “not too distant future.” Meanwhile, at Chevron’s analyst day earlier this month, the company essentially drew a line under the multi-billion dollar projects that have turned off shareholders in recent years while simultaneously talking up growth prospects in its Permian shale assets.
This re-balancing of the oil market is exactly what is being delayed by the effect of high debt and ultra-low interest rates. But any spike would have two edges.
The lesson of 2008’s spike for OPEC is that while it may want higher prices, what it really needs are stable prices that aren’t too high. On that basis, rather than hoping to destroy shale with its current policy, OPEC is likely counting on it to act as something like an automatic stabilizer for the oil price in future.
The other wild card here, though, is the Fed’s timing on raising rates further. When this happens eventually, it could have two very negative effects on the debt-laden oil market.
First, cheap financing is helping to keep bulging oil inventories in their tanks. Wednesday’s weekly report from the Energy Information Administration showed, yet again, that stocks are far above normal levels. When oil prices rally, though, this squeezes the profits that can be earned by buying oil and storing it to sell at a future date. The spread between the cash price and the six-month forward contract has more than halved since mid-February
You know what else squeezes a carry trade and could force those millions of barrels back onto the market? The cost of financing the trade going up.
The second impact of rising Fed rates goes back to Caruana’s speech. The explosion of borrowing in emerging markets, especially when denominated in U.S. dollars, is a ticking time bomb for the global economy. When rates start rising, pulling the value of the dollar up with them, the pressure on not just oil companies but all heavy borrowers in developing markets will intensify. And it just so happens that the developing world accounts for all of the projected growth in oil demand over the next five years, based on the IEA’s numbers.
Yellen’s caution, like OPEC’s freeze tease, bolsters the extend-and-pretend oil market. The debt always comes due at some point, though.
One of the biggest risks to the world’s financial system is the $2.5 trillion of debt owed by oil and gas firms. After a year from hell, prices of commodities, and the shares and bonds of the firms that produce them, have bounced in the past month. But the evidence of financial pain is all around. Last week Energy XXI, an explorer with $4 billion of debt, filed for bankruptcy in Houston. And JPMorgan Chase, Wells Fargo and Bank of America complained of rising energy-sector bad debts in their first-quarter results. Only 5% of global energy debt sits on the balance-sheets of America’s biggest three banks. A further 34% of global energy debt comes in the form of US-listed bonds. The majority of global exposure is hidden in smaller banks or beyond America’s borders. With a Saudi-led attempt to curb oil output ending in failure yesterday, expect more yelps.