Reverse Oil Shock: Part 3 – Feeding Financial Instability

Financial markets have generally assumed lower oil prices are positive for asset prices, resulting from the positive effect on growth and lower inflation which extends the period of low interest rates. In reality, the large movement in oil prices has the potential to create significant financial instability.

Monetary Disorder…

Lower oil prices will reduce already low inflation levels, entrenching expectations of price falls feeding a deflationary spiral.

Lower oil prices will be especially problematic for the Euro-zone and Japan, both of which are trying to increase inflation to boost nominal growth and manage high debt levels. The European Central Bank (“ECB”) estimates that around 80 percent of the fall in inflation levels between 2011 and 2014 was from lower oil and food prices. In Japan, other than the one-off effect of a consumption tax increase, rising energy prices, driven by a declining Yen, has been one of the few sources of inflation. Lower oil prices are now offsetting the effects of the weaker Yen reducing already low inflationary pressures.

This feeds significant policy differences between central banks. The US Federal Reserve has signalled a normalisation of interest rates, beginning in 2015. It views the oil shock as positive for growth, fuelling activity in an economy where wages and capacity utilisation is increasing. In contrast, the ECB views the oil shock as adding to deflationary pressures, requiring further aggressive easing to stimulate activity and increase inflation to target levels.

Falling oil prices and low inflation may encourage central banks to continue their policy of low interest rates for longer than anticipated.

Equity Disorder…

Expectations of higher disposable income and improved consumption have driven rallies in consumer stocks. Airlines, large consumers of oil, have also benefitted. But the position of airlines is complicated by hedges. These may delay the effects of lower fuel prices on costs. Derivative contracts locking in purchases prices are now out of the money, potentially requiring airlines to post collateral to secure positions creating large cash outflows. In previous episodes, this confluence of events has created problems for hedgers, occasioning bankruptcy or restructuring.

Energy related stocks are adversely affected by the fall in oil prices. Each dollar fall in oil prices equates to a one percent fall in American producer profits. In the short run, producers will maintain production as long as it covers variable operating costs. If prices remain low for an extended period, costs, production and investment will fall, perhaps dramatically. Industry estimates suggest that if the oil price remains around US$60 then investment may fall by up to 50 percent and production growth would cease.

The effects of lower investment and activity will affect oil service firms and equipment suppliers. Earning, cash flow and asset values will all be affected. Schlumberger, the world’s largest oil services group, has already announced job cuts and a US$800 million written down on the values of its fleet of ships engaged in offshore geological surveys, in response to lower oil prices and expected slower growth in oil exploration and production. Schlumberger shares have fallen around 20 per cent. Halliburton’s shares have fallen 40 per cent, exacerbated by its top of the market purchase of Baker Hughes, US$31 billion in cash and shares deal.

Equity investors, with large exposure to energy, have suffered large losses. Private equity firms have lost around US$12 billion in energy investments.

Businesses with investments in economies adversely affected by lower oil prices will suffer losses. BP has indicated significant losses from lower earnings and dividends from its investment in Rosneft, Russia’s state-owned oil company. Other energy companies will also be affected. Companies as disparate as Apple, McDonalds, Ikea and luxury product makers have reported slowdowns in activity as this second order contagion occurs.

Debt Disorder…

The real source of instability is likely to be debt markets. Heavily indebted energy companies and sovereign or near sovereign borrowers with large oil exposures face increased risk of financial distress.

The boom in borrowings by energy businesses, especially shale gas and oil producer, has created a dangerous debt overhang. Energy companies now make up around 15 percent of the Barclays US Corporate High-Yield Bond Index, up over 300 percent from less than 5 percent in 2005. Since 2010, energy producers have raised US$550 billion of funds, through new bonds issues and loans. In 2014, over 40 per cent of new non-investment grade syndicated loans were to the oil and gas sector.

The debt was at very low returns, reflecting the credit spread compression over the last few years. It frequently offers minimal investor protection.

During the boom, non-investment grade bond issues and loans for the oil industry was underpinned by high oil prices and the search for yield. Now low oil prices have reduced revenues sharply, making it difficult to service debt. Current bond prices, some around 60 to 70 percent of face value, suggest a sharp increase in risk of bankruptcies and defaults.

The industry’s weak financial structure and business model compounds the problem. A significant proportion of the industry is highly levered with borrowings that are greater than three times gross operating profits. Many firms were cash flow negative even when prices were high, needing to constantly sink new wells, usually debt funded to maintain production.

If the firms have difficulty meeting existing commitments, then the decrease in available funding and higher costs as debt market close for these firms will create a toxic negative spiral. Inability to borrow will reduce production capacity from short-lived shale-oil wells where output can fall by 60-70 percent after the first year. Lower production combined with low prices will reduce cash flows increasing the risk of default, further restricting the supply of debt to the sector setting off a new cycle.

Sovereign and near sovereign borrowers in oil dependent countries are similarly vulnerable. Energy companies, such as Brazil’s Petrobras, Mexico’s Pemex and Russia’s Gazprom, are among the largest issuers of emerging market debt. Since 2009, they borrowed around US$140 billion in bond markets. Petrobras has around US$170 billion in debt, one of the most indebted companies in the world. Russian energy companies such as Gazprom, Rosneft and its major banks have issues nearly US$250 billion worth of bonds since 2009.

Political risk attenuates the problems of lower oil prices. Petrobras is entangled in a corruption scandal. Western sanctions prevent Russian companies from new borrowing or refinancing existing international debt. They also increase the risk that theoretically independent sovereign owned firms are allowed to default, for geo-political reasons.

The interest rates of this debt have increased. Petrobras 10-year interest rates have increased to around 8 percent from 6 percent. Pemex rates have increased to 4.8 percent from 3.8 percent. Russian rates have increased even more dramatically, with Gazprom trading at distressed levels of over 10 percent up from 6 percent. Pricing of Venezuelan foreign debt in financial markets is consistent with a high risk of default.

Many oil dependent economies also face additional problems from a growing currency mismatch. Many producers borrow in US dollars to match the currency of revenues and underlying assets. Falling oil revenues as a result of lower prices reduce the US dollar cash flow available to service the debt. Weak oil prices also drive weakness in the value of the domestic currency of oil producers, with significant falls already experienced. A stronger US dollar and higher US dollar interest rates compound the mismatch, creating potentially significant currency losses. Where the level of borrowings is high, this increases the risk of failure to make timely payments.

For oil producing nations, the financial problems of large, state-run producers have broader economic implications. Lower earnings, reduction in investment, lack of availability of finance and currency devaluation will lead to a weaker economy. In turn, this drives defaults, financial system problems and further reduction in access to international funding. The problems have increasingly spread from oil dependent economies to all emerging markets, affecting debt pricing and financing availability.

Reverse Recycling…

A complicating factor is the fall in the supply of petrodollars resulting from the fall in oil prices, which has been an important channel of US dollars to emerging markets.

Since the first oil shock, petro-dollar recycling has been an essential component of global capital flows. Historically, surplus revenues from oil exports accruing to producers accumulate as currency reserves that are reinvested in G-3 currencies (US$, Euro and Yen).

Originally, these flows were invested predominantly in government or high quality securities. More recently, the petrodollars have been invested in a wider of assets, including equities, trophy real estate, sporting teams and high-end art.  It also now encompasses emerging as well as developed markets. This flow has increased global liquidity flows, helping finance budget and trade deficits, boosting asset prices as well as keeping interest rates low.

The sharp fall in revenues will reduce the growth in reserves and the investment capital available. For example, a US$10 per barrel fall in oil prices has a corresponding US$70 billion (around 4 percent of GDP) effect for members of Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates) alone. If the downturn is not short lived, then realisation of these reserves may become necessary. This would be a historic event, being the first time in twenty years that the oil producing nations will not be a source of liquidity to the global financial system.

A prolonged period of low oil prices will reduce petrodollar liquidity and drawdown of foreign assets. This has potentially important implications for the value of the US dollar, asset prices and interest rates globally.

It will also add to pressures on increasingly fragile emerging markets.

Emerging markets have around 75 percent of its US$2.6 trillion debt denominated in US dollars. A similar proportion of emerging market borrowings from banks of US$3.1 trillion is denominated in US dollar. The large amount of US dollar borrowing reflects the low interest rates and size of the dollar market. But now the tightening of dollar availability is compounding the effects of a stronger dollar, weak local currencies and higher US rates.

Losses will affect bank and investors. Debt issued by major oil producers is held widely by insurance companies, pension funds, fund managers and retail investors. Structured finance arrangements, such as collateralised loan obligation (“CLOs”), which contain non-investment grade loans to energy companies will add to the contagion.

Low oil prices and the risks in the market of the debt of energy companies is increasingly exposing the dangers of low interest rates, QE and resulting asset price bubbles. The risk of a potential credit crisis is now real.

The Oil Complex…

The new oil shock, if it persists, will have profound consequences for the global economy and geo-political order. Its benefits are mixed, uncertain and unevenly distributed. Its effects on debt markets and emerging economies have the potential to trigger a profound adjustment in the asset price bubbles that have been created by the innovative monetary policies in the aftermath of the Great recession.

The long term environmental consequences of low oil prices are negative, reducing incentives for conservation and investment in renewable energy sources. It risks increasing emissions, increasing carbon intensity and reducing energy efficiency.

Professor Jeffrey Sachs and other argue that low oil prices provide a historic opportunity to introduce proper carbon pricing schemes. Low oil prices would mitigate the effects of the tax, with energy price still below their levels of the recent past.

The effect of such a carbon tax would be to properly reflect the environmental cost of the emissions from fossil fuels. It would provide an appropriate price signal, encouraging reduced investment in stranded fossil fuel assets and greater focus on renewable energy. Carbon taxes would also provide much needed revenue for government, some of which could be invested in low-carbon energy. Of course, the chance of any political progress on these initiatives is negligible.

© 2015 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money