Jon Markman: While it is tempting to see the 38 percent plunge in oil prices since mid-June as benign and positive for the U.S. economic recovery, there is a nasty downside to the story.
Banks and investors have loaned tens of billions of dollars to energy producers to develop new sources of energy in areas ranging from the shale fields of North Dakota to the deep seas off of Brazil and western Africa. The decline in oil price has led to an increasing danger that these loans and bonds may go bad, and that would be not only terrible for energy investors but also for the banks and other lenders.
|The dramatic slide in the price of oil is beginning to reverberate through the wider economy.|
A story in the Financial Times, “Oil price fall starts to weigh on banks,” explained the situation well. Citing just one example of many, it noted that Barclays, Wells Fargo and other banks are facing potentially heavy losses on an $850 loan made to two oil and gas companies. The looming blow-up shows how the dramatic slide in the price of oil is beginning to reverberate through the wider economy, hitting currencies and national budgets in addition to energy company shares.
The Russian ruble has lost 27 percent of its value since mid-June, when crude began to fall by 30 percent, while the Norwegian krone is down 12 percent and on Wednesday the Nigerian naira touched a record low. Some of the worst-hit big companies are BP (NYSE:BP), down 17 percent, and Chevron (NYSE:CVX), off 11 percent.
Last week, shares in Seadrill, one of the world’s biggest drilling rig owners, fell 18 percent after it suspended dividend payments. The company has suffered from an oversupply of rigs as the majors respond to crude’s slide by cancelling projects.
A loan arranged by UBS and Goldman Sachs to help private equity group Apollo buy Express Energy Services was supposed to be completed earlier this week but appears to have been postponed, according to market participants.
Marty Fridson, chief investment officer at LLF Advisors, told the FT that of the 180 distressed bonds in the Bank of America Merrill Lynch high-yield index, 52, or nearly 29 percent, were issued by energy companies. Energy bonds make up 15.7 percent of the $1.3 trillion junk bond market, according to Barclays data, compared with 4.3 percent a decade ago.
Next shoe to drop: The oil price wipeout could have a big effect on credit markets as U.S. regulators discourage banks from making riskier loans.
In short, it is too simplistic to merely suggest that the decline in the price of oil is a big plus that provides U.S. consumers with a virtual tax cut. Instead, it could threaten the recovery if existing bonds and loans blow up, preventing lenders from providing credit to deserving firms in other industries.
For companies like Seadrill, the ability to raise cash in the corporate bond market is now jeopardized as more and more wellheads, in which exploration and production funds have already been sunk, become unprofitable to operate.
While the U.S. economy has been putting in a robust performance lately, the global economic picture shows a different story as the energy wipeout ripples. Cornerstone Macro analysts said they believe oil prices could fall roughly another 30 percent — back toward 2008-2009 financial panic lows — because the global macroeconomic backdrop “is not positive for commodity prices.”
The bottom line: Expect defaults and bankruptcies among oil producers with costly drilling programs. In a Bloomberg News interview, Russian oil magnate Leonid Fedun calls this a “major strike against the American market” and compares the rush of investment into the sector to the dot-com boom.
This adds pressure to a junk bond market that has been decidedly less enthusiastic than stocks have been of late. The SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) doubled-topped in July and September (with stocks) and has been sliding lower ever since in a pattern of lower highs and lower lows. This comes as Treasury bonds have been rallying, widening the yield spread between junk bonds and T-bonds to levels not seen since the start of the year.