The crashing oil price is now a market crisis problem
While I try not to be too alarmist here, it is clear now that the drop in oil prices has been both precipitous enough and long-enduring enough that we should start talking about this as a crisis in the making. We have an interconnectedness here of a strong dollar, weak oil and commodity prices, a move into safe assets and a flight from risk driving volatility and global asset allocation. Emerging markets, energy high yield and Greece are the flash points right now. Some thoughts below
In October, when I first brought up the potential for crisis because of the fall in oil prices I wrote that, “what I am looking to see is how long this slump in prices last. And what I expect to happen is that if it lasts more than a few weeks, we are going to see liquidity in the shale oil funding market dry up and then the companies with the worst cash flow positions will run into trouble and default.” We are now into a few months of this slump in prices and so we should expect the defaults to begin, perhaps as soon as this quarter given the continued drop in oil prices to below $50 a barrel.
The way I would look at the market now is as a tiered-market. Though recent events might call this into question, I would say we are now into a period in which cheap oil is in permanently short supply. And so the price of oil now rises and a boom ensues to where it is profitable to develop new sources of oil. The problem is that as the price of oil rises, a whole slew of oil exploration and development opportunities arise that tip the supply demand imbalance temporarily into supply glut territory, causing a bust. We are in the bust phase of the cycle. And given how quickly this bust has developed and how low prices have gone, I would call this a market panic, a crisis that is developing before our eyes.
Now, let’s remember that when prices were much higher back in October, I wrote that “my understanding based on conversations with people familiar with this market is that many projects are not profitable below the $80-90 level.” And so I see the $75-80 level as a tipping point below which negative scenarios develop rapidly. Since I wrote the first shale piece, however, a lot of analysis has come out suggesting that shale oil can be developed profitably well below the $75-80 tipping point. I would caution you to view these analyses with scepticism.
A recent interview with geologist Arthur Berman highlights this issue and the exchange about the shale oil landscape below is important to consider:
OP: How do you see the shale landscape changing in the U.S. given the current oil price slump?
Arthur Berman: We’ve read a lot of silly articles since oil prices started falling about how U.S. shale plays can break-even at whatever the latest, lowest price of oil happens to be. Doesn’t anyone realize that the investment banks that do the research behind these articles have a vested interest in making people believe that the companies they’ve put billions of dollars into won’t go broke because prices have fallen? This is total propaganda.
We’ve done real work to determine the EUR (estimated ultimate recovery) of all the wells in the core of the Bakken Shale play, for example. It’s about 450,000 barrels of oil equivalent per well counting gas. When we take the costs and realized oil and gas prices that the companies involved provide to the Securities and Exchange Commission in their 10-Qs, we get a break-even WTI price of $80-85/barrel. Bakken economics are at least as good or better than the Eagle Ford and Permian so this is a fairly representative price range for break-even oil prices.
But smart people don’t invest in things that break-even. I mean, why should I take a risk to make no money on an energy company when I can invest in a variable annuity or a REIT that has almost no risk that will pay me a reasonable margin?
Oil prices need to be around $90 to attract investment capital. So, are companies OK at current oil prices? Hell no! They are dying at these prices. That’s the truth based on real data. The crap that we read that companies are fine at $60/barrel is just that. They get to those prices by excluding important costs like everything except drilling and completion. Why does anyone believe this stuff?
If you somehow don’t believe or understand EURs and 10-Qs, just get on Google Finance and look at third quarter financial data for the companies that say they are doing fine at low oil prices.
Continental Resources is the biggest player in the Bakken. Their free cash flow—cash from operating activities minus capital expenditures—was -$1.1 billion in the third- quarter of 2014. That means that they spent more than $1 billion more than they made. Their debt was 120% of equity. That means that if they sold everything they own, they couldn’t pay off all their debt. That was at $93 oil prices.
And they say that they will be fine at $60 oil prices? Are you kidding? People need to wake up and click on Google Finance to see that I am right. Capital costs, by the way, don’t begin to reflect all of their costs like overhead, debt service, taxes, or operating costs so the true situation is really a lot worse.
So, how do I see the shale landscape changing in the U.S. given the current oil price slump? It was pretty awful before the price slump so it can only get worse. The real question is “when will people stop giving these companies money?” When the drilling slows down and production drops—which won’t happen until at least mid-2016—we will see the truth about the U.S. shale plays. They only work at high oil prices. Period.
Up until now I have focused mostly on the growth dividend from the drop in oil prices. But now, three months after my initial article on shale and with prices now below $50 a barrel, I believe the focus should shift to the potential that a crisis is developing.
Here’s the thing I think is the problem. As I put in October “what we should be concerned about here is that, just as with subprime mortgages, this is not a particularly big market but one with interconnections to others.” Let me give you an example. A friend of mine recently told me that the underwriters at the bank she worked for were talking in hushed tones with concern about credit lines and loans they had to players lending to the shale oil sector. This bank is not one closely associated with the oil sector. So, nowhere on its balance sheet or SEC filings will you see anything that indicates that their balance sheet is leveraged to oil. Yet, they are worried. What’s important here is that their concern is not loans they made to oil players but rather loans they made to banks or players who themselves made loans to shale plays. That’s contagion. And this is how crises happen. It’s not that the locus of market turbulence is large. Rather it is that the interconnections in our financial system create liquidity problems that expose existing financial fragility. The question then is where that fragility lies.
I would point in three directions here.
Emerging markets are one area I believe is vulnerable. Take a look at this chart that Raoul Pal posted on Twitter.
— Edward Harrison (@edwardnh) January 4, 2015
This chart is telling you that emerging market equities have been highly correlated with movements in the US dollar over the past decade. That’s the genesis of Guido Mantega’s famous “currency war” tirade. But what we see developing since 2014 is a strong move to the upside in the US dollar index that has not been followed by a concomitant down move in Emerging equites. This chart is telling you then that emerging markets are extremely vulnerable going into 2015.
I have an article going up at Foreign Policy magazine this week on exactly this topic and the gist of what I wrote is that Russia is just the canary n the coal mine here. As the strong dollar and weak commodity prices take their toll, I believe we are going to see emerging markets under pressure.
Another area to look at is high yield. Of course, we should look at energy high yield. That’s the first place we should be looking in fact because that’s where the defaults are going to happen. Here’s the problem: even though we have heard that capital expenditure in the oil patch is being cut massively, shale production in 2015 will actually rise due to the number of wells already drilled. That means that oil prices will remain under pressure, making it likely that a number of companies with high breakevens and a lack of cash on their balance sheet will have to default. Bloomberg is talking about $1.6 trillion in lost earnings for 2015 alone. And while that means cutbacks in drilling plans, it doesn’t mean cutbacks in existing drilling rigs or production. For example, Peter Boockvar of the Lindsey Group noted recently that although the oil rig count is falling and at its lowest level since April, it is still up against year ago levels. The bottom line is that there is no relief in sight. The earliest we could see relief probably is the next OPEC meeting in June. Maybe OPEC and Russia will coordinate a cut in output. I don’t know. But I don’t expect anything until then. That spells trouble for energy high yield and high yield more generally.
A last area to think about is Europe. Here, Europe should be getting an oil dividend. But this will be completely offset by the sovereign debt crisis, which means a flight to quality. Robin Wigglesworth posted the following chart on Twitter, showing falling bond yields.
— Edward Harrison (@edwardnh) January 5, 2015
My take here is that the Euro crisis is creating a lack of safe assets in the euro zone, driving down yields on Bunds. Yes, some of this is related to deflation concerns and lower expectations of future policy rates but I believe a lot of this is a flight to quality. And this is not a problem monetary policy can easily solve. QE cannot reverse yield compression if it is driven by a flight to quality and away from risk unless the central bank reduces default risk by taking risk assets onto its balance sheet as the Fed did in QE1, what Ben Bernanke called “credit easing”. I don’t see the ECB doing this, first because not enough of the private market-based financial assets exist. That’s why the ECB is talking about sovereign QE. But even on sovereign assets, the ECB is only willing to buy assets that are more highly rated, leaving private portfolio preferences to shift into riskier assets. That’s not going to happen when you have a sovereign debt crisis since the prevailing mentality is risk-off.
There are opportunities though. If bond market guru Jeff Gundlach is right, the yield on treasuries will go even lower than they presently are. In fact, I would say the big outliers on safe asset yields are the Anglo-Saxon economies like the US, the UK, Canada, New Zealand and Australia. So, that’s where the upside potential in 2015 is. Convergence of Anglo-Saxon sovereign bonds to the norm is likely to be toward lower yields as the emerging crisis takes hold.
The main point here though is that the crashing oil price is now a market problem rather than an economic lift. And we will feel the impact in both bonds and equities.