The Sub-Prime Mortgage Loan – Loans to Oil & Gas Producers?

We all know that bundles of incorrectly-credit-rated subprime real estate mortgages were the heavy, lead-pipes that crushed the camel’s back and led to the 2008 collapse of several “too big to fail” Wall Streeters. Financial institutions, themselves borrowed to the hilt based on bundles of these bad mortgages, led the world into the Great Recession. Real estate prices plunged, particularly in the lower-end residential market, as borrowers without an ability to carry variable interest debt bought over-valued homes… and ultimately defaulted en masse.

Complaining of over-regulation, the big banks (commercial, merchant, and investment) told us that they were perfectly capable of policing themselves, all as their palms were outstretched to receive government bailout money… for those financial players who survived their own folly.  A few, like Lehman Bros. and Bear Stearns, didn’t make it.

So with these statements of competent self-regulation (“get the government out of our hair”), knowing that senior financial executives will never go to jail no matter how outrageous their conduct, have these Wall Streeters learned their lesson? Or is there a less-than-obvious sleeping dog that underlies even the contraction of the Chinese economy (and its concomitant reduction in demand for commodities), the replacement of labor with automation and the general global instability? Yep! Too many loans based on and secured by oil and gas assets. So while this is another longer blog, hang in there, because your financial life is hanging in the balance.

The oil and gas industry was focused on expansion as the economy sputtered back to life in 2011 and as American fossil fuel producers discovered the magic of fracking – using chemically treated water to pressure pockets of trapped oil and gas that had once been written off as unreachable. The United States soon became one of the world’s greatest oil producing nations; the need to import oil other than from our North American neighbors vaporized. Oil and gas producers, with proven reserves, borrowed to fuel that expansion. All the way through the middle of 2014, oil prices were well over $100/barrel, a solid basis for loans… or so these institutional lenders believed. Oil and gas had no place to go but up. Right!

As the above oil price chart from the New York Times (January 21^st) illustrates, those assumptions were unsustainable. Today oil is priced at its lowest point since 2004. There are claims that Saudi over-production was aimed at bankrupting the high-cost frackers, allowing them to reclaim their control of oil pricing. The cut in demand by a contracting Chinese economy also exerted a downward pull on oil, and the clear ability of a de-sanctioned Iran to market its petroleum loomed above an already glutted fossil fuel marketplace.

“The oil industry, with its history of booms and busts, is in its deepest downturn since the 1990s, if not earlier… Earnings are down for companies that have made record profits in recent years, leading them to decommission roughly two-thirds of their rigs and sharply cut investments in exploration and production. An estimated 250,000 oil workers have lost their jobs, and manufacturing of drilling and production equipment has fallen sharply…

“In the United States, Alaska, North Dakota, Texas, Oklahoma and Louisiana are facing economic challenges…Chevron, Royal Dutch Shell and BP have all announced cuts to their payrolls to save cash, and they are in far better shape than many smaller independent oil and gas producers that are slashing dividends and selling assets as they report net losses. Other companies have slashed their dividends… About 40 companies in North America have gone into bankruptcy protection.” NY Times.

That’s bad enough if you’re in the oil industry, but aren’t lower prices good for everyone else? It’s cheaper to ship goods, consumers have more discretionary income to spend and for most companies there have been significant reductions in operating costs resulting from generally lower prices in the energy sector.

Except for one nasty variable. Financial institutions that are the lifeblood of the entire economy have been slammed, once again, by over-lending against over-valued assets… this time in the oil and gas sector. With cheap money, oil producers flocked to the debt trough, and lenders, buoyed by high oil prices, were happy to step into the void. Other, non-petroleum companies, have also borrowed, and their collateral is also eroding with the fall of their share prices in the current market.

As oilprice.com explains, there are significant continuing risks to these financial institutions that will slowly be released to the public under financial disclosure laws:

·         Increased debt defaults. Increased debt defaults of many kinds can be expected, including (a) Businesses involved with oil extraction suffering from low prices (b) Laid off oil workers not able to pay their mortgages, (c) Debt repayable in US dollars from emerging markets, including Russia, Brazil, and South Africa, because with their currencies now very low relative to the US dollar, debt is difficult to repay (d) Chinese debt related to overbuilding there, and (e) Debt of failing economies, such as Greece and Venezuela.

·         Rising interest rates. With defaults rising, interest rates can be expected to rise, so that those making the loans will be compensated for the rising risk of default. In fact, this is already happening with junk-rated oil loans. Furthermore, it is possible that the US Federal Reserve will raise target interest rates [going forward]. This possibility has been mentioned for several months, as part of normalizing interest rates…

·         Defaults on derivatives, because of sharp and long-lasting changes in oil prices, interest rates, and currency relativities. Securitized debt may also be at risk of default…

·         Drop in stock market prices. Governments have been able to “pump up” stock market prices with their QE programs since 2008. At some point, though, higher interest rates may draw investors away from the stock market. Stock prices may also decline reflecting the poor prospects of the economy, with rising unemployment and fewer goods being manufactured.

·         Drop in market value of bonds. When interest rates rise, the market value of existing bonds falls. Bonds are also likely to experience higher default rates. The combined effect is likely to lead to a drop in the equity of financial institutions. At least at first, this effect is likely to occur mostly outside the US, because the “flight to security” will tend to raise the level of the US dollar and lower US interest rates.

Experts are also telling us that the benefits to our general economy are far less than the damage that has rippled through our financial well-being from the plunge in oil prices: “In the United States, increased production of oil and gas also has reduced reliance on imports, so a larger share of the dollars consumers saved at the pump came at the expense of domestic oil and gas producers, offsetting a larger share of benefits.

“Only 27 percent of the petroleum consumed in 2014 was imported, the lowest share since 1985, according to the United States’ Energy Information Administration… Moreover, those benefits were smaller than many expected as Americans saved a slightly larger share of their incomes last year. Since mid-2014, personal savings rose by about $120 billion, an amount roughly equal to the savings at the pump, according to Capital Economics.

“Interestingly, a study of credit card spending by the JPMorgan Chase Institute found that people spent much of the gas windfall on more gas… The problem, in other words, may have been that people were slow to increase spending from other sources of income.

“Some analysts see evidence that consumers are saving because they are scared, or still struggling to pay down high levels of debt. Others, however, are more optimistic. They argue that consumers hesitated initially because they weren’t sure lower prices would last, but that spending will increase as lower gas prices endure.” New York Times, January 21^st.

But some think there is a lag in the upswing in our economy and that the worst is over, at least as far as our domestic markets are concerned: “Consumer spending has started to rise more quickly, James Bullard, president of the Federal Reserve Bank of St. Louis, noted in a speech [in mid-January], describing it as ‘mild evidence’ that falling prices are lifting domestic growth.

“‘For the macroeconomy as a whole, the relatively low crude oil prices the U.S. is enjoying today are likely a bullish factor,’ Mr. Bullard said in Memphis… But Mr. Bullard added that lower prices might be causing a different, longer-term economic problem by contributing to the erosion of inflation expectations… The Fed [Federal Bank] aims to keep prices rising about 2 percent a year. It also seeks to maintain public confidence that it will meet that goal, which it regards as critical because expectations play an important role in determining the pace of inflation.” NY Times. Still, you just have to look around you and ask some really embarrassing questions. Do feel confident about the economy? Exactly where is the new growth really going to come from? And who gets to cover those losses from failed “big-lender” debt?

Nobody is predicting the rising of oil prices anytime soon, so any hope that the collateral underlying so many loans will rise to support the debt assumptions remains illusory at best. And once again, the financial sector has been caught with its pants down. So the damage from such falling oil prices is hardly relegated to the oil and gas sector alone; the underlying financial instability among some our largest institutions will impact us all. The aggregation of negative variables – from the “China contraction” to this over-leveraging in the oil and gas sector – probably won’t remotely reach the levels of financial disruption that caused the 2008 market fall. I think we are still all in for a rough ride as all of the markets, from basic equities, asset-based lending, real estate and overall liquidity adjust to these changes.

I’m Peter Dekom, and in this complex world, it helps to understand the biggest pieces with the greatest impact on our daily economic reality.