As I write this, the price of Crude Oil is down roughly 50% from its 2014 peak of $107.60, made exactly 6 months ago in June. It is currently the biggest single issue in the financial world, with economists and pundits debating the consequences of every tick lower. There are a few major themes being discussed – the possible reversal of fortune for countries such as Russia, Venezuela, and to a lesser extent Canada and the much talked about US oil boom. There is also some optimism that a lower oil price will lead to lower energy costs which in turn will boost the spending power of the average consumer, which in turn will increase spending and economic growth. These issues, while significant, ultimately pale in comparison to the larger issue of underlying monetary conditions, potentially burst bubbles, and contagion. The true impact of the rapid decline in oil will not be known for another few months or even longer, as the inner workings do take time to play out, but the implications aren’t great.
As I wrote two months ago in reference to the ending of Quantitative Easing by the Federal Reserve:
Indeed, within the post 2008 monetary regime, we have seen two instances of effective monetary tightening, namely the ends of the original QE and QE2. Ending in March 2010 and June 2011 respectively, their passing resulted in immediate drops in the S&P 500 (which I use here as a proxy for asset prices…) of 16% and 21.8% respectively. Currently, the Federal Reserve is in the closing stages of tapering the latest round of QE, providing the economy another chance to show that it can stand on its own two feet.
One of the main themes of this blog has been the rubbishing of the idea that the Federal Reserve can mitigate recessions by first supporting asset prices, then removing the training wheels later on when the economy is ready to support itself. In a sentence, the reason why this theory is doomed to fail is that a model for economic growth that rests on constant rises in asset prices cannot sustain those constant rises in the face of declines (absolute or relative) in the supply of money and credit, which is what is induced by the removal of the training wheels in the latter phases of the Fed’s policy cycle.
In embarking on tapering QE, the Federal Reserve has initiated a process by which the areas to which its cheap money flowed into will soon face difficulty because less money will be flowing into those areas. This creates a situation in which latecomers to the game have overextended themselves. They have paid high costs for production, and likely taken on loans in order to do so. Owing to the reduced flow of cheap money and credit, the higher prices needed to cover the original costs and interest payments may not be forthcoming. This is a recipe for bankruptcies and defaults, with the contagion spreading the more exposed the financial sector is to the mess.
Since early 2010, energy producers have raised $550 billion of new bonds and loans as the Federal Reserve held borrowing costs near zero, according to Deutsche Bank AG
The Fed’s decision to keep benchmark interest rates at record lows for six years has encouraged investors to funnel cash into speculative-grade securities to generate returns, raising concern that risks were being overlooked. A report from Moody’s Investors Service this week found that investor protections in corporate debt are at an all-time low, while average yields on junk bonds were recently lower than what investment-grade companies were paying before the credit crisis.
The Wall Street Journal also noted that, with respect to energy producers in the Americas during 2014, ‘the $145.9 billion in bonds issued by companies from the Americas hit a year-to-date record, even as global borrowing for the industry fell to its lowest level since 2011’.
Schwab notes the following:
Today, energy companies make up more than 15% of the Barclays U.S. Corporate High-Yield Bond Index. That’s up from less than 5% of the index at the end of 2005—and the chart below shows that the share has been steadily increasing over the past decade. In fact, the energy sector now has the second-largest weighting in the high-yield bond index, trailing only the communications sector, which accounts for more than 18% of the index. At the end of 2005, the energy sector was only the seventh-largest weight in the index.
The chart in question:
The persistence of nonexistent borrowing costs over the last half decade led to the proliferation of loan issuance, a substantial portion of which clearly made its way into the energy sector. This sector is very capital intensive, requiring huge outlays up front which are largely financed through bond issuances. Over the course of the five year rise in energy related debt from mid 2009 through June 2014, the price of oil fluctuated between just under $70 and $110 per barrel, with the vast majority of that time seeing prices north of $80. This means that the relatively elevated prices of that period served to elevate the costs of energy producers, thus increasing the amounts they needed to borrow to finance their projects. The perceived continuance of oil prices at elevated levels justified the borrowing.
With oil now trading below $60 per barrel, those dynamics have been drastically altered. Many wells that have recently come on line are pumping out a product that now sells for less the cost of its production, particularly if it is in the hands of a smaller company which got in over its head. Should the oil price persist at lower and lower levels, the predictable course of action for troubled firms becomes drastic cost cutting, closing of rigs, and layoffs. Knock on effects include the depression of support businesses in oil producing regions, such as restaurants, hotels, and local shopping centers. This Bloomberg article, fore example, mentions a Sam’s Club in Midland, Texas which pays its workers $20/hr. If the oil money dries up, so does the income for workers in these businesses.
Collectively speaking, the inability for oil companies to service the mounting debt taken on just a few years prior becomes an increasingly likely possibility with each the continued drop in the oil price. This presents a problem for anyone holding these corporate bonds, many of them being of junk status. A little over two years ago, when the rise of junk bonds was first being mentioned in the mainstream, I noted it in a piece about the nature of the US recovery, citing this quote from a NYT article about the subject (emphasis mine):
Companies with junk credit ratings have been increasingly issuing bonds for riskier purposes that could hinder their ability to pay back bondholders.
Demand for junk bonds has touched record levels this year as investors reach for their rich yields, a stark contrast to the meager returns available on Treasury securities and money market accounts. But the voracious demand has allowed companies to easily raise money for things that may actually end up weakening them.
My main focus at the time was the expanding subprime auto market, but the issues raised easily apply to the oil production industry. Rock bottom interest rates created an incentive to ‘chase yield,’ which created demand for higher yielding, but more risky bonds financing oil enterprises. The bag holders are the banks who issued the debt, as well as the hordes of investors, individual and institutional, which piled into the high yield space in order to take advantage of the opportunity presented at the beginning of the boom. From Schwab:
The graph shows the inflows into what Morningstar deems to be “High Yield” mutual funds. Long story short, that graph represents a lot of money which went to the purchase of what is very likely to be very bad debt. That realization will undoubtedly lead to an attempt to exit en masse, which is never a pretty sight for the asset in question. The following graph from Zero Hedge sets up the next domino to tumble in that event, the US financial sector itself:
While credit spreads have not blown up just yet, it is only matter of time if the widespread issues in the oil sector continue to be protracted by a depressed oil price. The real problem is the financialization which took place over the last few years. Having grown with the oil boom, it must now be unwound with an oil bust. It is very possible that the oil boom and bust of the last few years is the catalyst that kicks off the next financial crisis and global recession, as the pressures of holding bad debt will weigh on everyone from the financial sector to pensioners, who as a result will not be able to engage in increased spending thanks to a newly compromised financial position.
As I wrote above, these are issues that will take some time to play out, but at the end of the day, how can the Federal Reserve commit to further tightening in the face of all of that? Perhaps Janet Yellen will speak to this in her press conference set for Wednesday. As far as I’m concerned, however, the FOMC is stuck between a rock and a hard place. Embedded in the bedrock of modern economic thought is the idea that the Federal Reserve has the capabilities to play the role of ultimate stabilizer, in that it can support the economy in down times while exiting when the good times reappear, without any problems when that time comes. To maintain that pretense, the Federal Reserve has to taper, and then tighten. Maintaining crisis policy in perpetuity shatters the illusion that the Fed is in control and can ever exit, which in turn shatters the underlying belief system which all of mainstream academia, Wall Street and the government adhere to. So at the very least an attempt at tightening must be made. However, that tightening is the death knell of the ‘recovery’ that has been built. The tremors in oil are beginning to show that, but since is still early in the process, expect some sort of ‘subprime is contained’ language to emanate from the usual suspects to ease any concerns.