Falling oil prices and and US shale drillers drowning in a sea of debt could be the spark for a new credit crunch
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Could falling oil price send the US recovery up in flames as drillers struggle with debt? Photo: REUTERS
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Remember the global financial crisis, triggered six years ago when billions of
dollars of dodgy loans - doled out by banks to subprime borrowers and then
resold numerous times on international debt markets - began to unravel and
default?
Stock markets plunged, banks collapsed and the entire global financial system
teetered on the brink of catastrophe. Well a similarly chilling economic
scenario could be set off by the current collapse in oil prices.
Based on recent stress tests of subprime borrowers in the energy sector in the
US produced by Deutsche Bank, should the price of US crude fall by a further
20pc to $60 per barrel, it could result in up to a 30pc default rate among B
and CCC rated high-yield US borrowers in the industry. West Texas
Intermediate crude is currently trading at multi-year lows of around $75 per
barrel, down from $107 per barrel in June.
“A shock of that magnitude could be sufficient to trigger a broader high-yield
market default cycle, if materialised,” warn Deutsche strategists Oleg
Melentyev and Daniel Sorid in their report.
Five years ago at the beginning of what has become known as the US shale oil
revolution, drillers started to load up on debt to fund their operations and
acquire new acreage as vast areas of North America started to open up for
exploration.
Latest estimates suggest that by the end of the decade the US will have outstripped even Saudi Arabia and Russia in terms of oil production. The development of new shale resources in North America and the opening up of fields in the Arctic seas off Alaska could see the country pumping 14.2m barrels per day (bpd) of oil and petroleum liquids by 2020, up from 7.5m bpd in 2013.
This rush to pump more oil in the US has created a dangerous debt bubble in a notoriously volatile segment of corporate credit markets, which could pose a wider systemic risk in the world’s biggest economy. By encouraging ever more drilling in pursuit of lower oil prices, the US Department of Energy has unleashed a potential economic monster and pitched these heavily debt-laden shale oil drilling companies into an impossible battle for market share against some of the world’s most powerful low-cost producers in the Organisation of Petroleum Exporting Countries (Opec).
It’s a battle the US oil fracking companies won’t win.
The problem is that much of America’s shale oil is expensive to produce and the industry is comprised of numerous small companies who were forced to leverage their operations with debt to fund the high cost of drilling wells through a process known as hydraulic fracturing, or fracking. Should oil prices fall for a prolonged period of time many who have been forced to borrow at a higher rate could be forced out of business and ultimately default.
According to research from JP Morgan Asset Management, of the 12 largest shale oil basins in the US, 80pc are barely profitable, with prices of oil below $80 per barrel. More worrying is that these projections don’t include interest payments on debt made by shale producers.
“These guys have taken on a lot of debt to fuel their operations in the US,” said Alex Dryden, an analyst at JP Morgan Asset Management. “As the oil price has fallen we have started to see a sell-off in debt and equities in this energy space in the last few months.”
According to Mr Dryden, the market has become increasingly concerned about the risks of US shale drillers being caught up in an oil price war with members of the Organisation of Petroleum Exporting Countries (Opec). He argues this has already been reflected recently in the US high-yield index and the increasing cost of insuring US high-yield assets in the shale oil industry.
Rig counts also suggest that US drillers are beginning to feel the pinch.
According to Baker Hughes, the number of rigs targeting shale oil in the US fell to the lowest level since August this week. Drilling companies in the massive Eagle Ford shale area of Texas shut down rigs at the fastest rate.
Although senior policymakers within Opec, including Saudi Arabia’s oil minister, have rejected the claim that the group is willing to absorb lower oil prices for the foreseeable future in order to squeeze US producers and Russia to win back market share, many analysts remain suspicious of the reasons why it has not already decided to cut its production target below its current ceiling set at 30m bpd of crude.
I am also sceptical of Opec's unwillingness to act.
The notoriously opaque group of 12 producers mainly from the Middle East controls about a third of the world’s supply of crude, down from about half 25 years ago at the height of its power to influence world markets. Of course Opec, which has been accused in the US of acting like a cartel, ultimately benefits from higher prices as most of the economies of its members depend on crude exports as their main source of foreign currency revenues, which suggests that any premeditated strategy by its leading members to force down prices will only be short lived.
Attention will now shift to Opec’s final meeting of the year on November 27, when the group’s oil ministers will gather in Vienna to decide on whether to cut production dramatically to restore prices back to levels around $100 per barrel. However, should Opec decide to keep its spigots open and drive prices lower then that could theoretically force some US drillers out of business, with potentially catastrophic consequences for high-yield debt markets and perhaps the global economy as a whole.
“The Opec meeting at the end of this month is the biggest in terms of global impact that we have seen in the last two decades,” said Mr Dryden. “But I think nothing will come out of it.”
Politically, cutting production is always a move Opec ministers are reluctant to take. Given the fragile state of the world economy and the opportunity to be seen in Washington to add economic pressure onto Moscow, it would be easy for the group to sit on its hands by keeping its quota unchanged and instead focus on compliance.
If this scenario plays out then US shale oil producers will be the biggest losers.
Of course, falling oil prices will also have a positive impact on major industrialised economies, helping to keep a lid on inflation and providing a welcome boost to consumption, which should follow on from lower fuel and energy costs for the general public.
“It’s like a tax cut. The European and the US economies will get a free lunch from lower oil prices,” said Mr Dryden.
According to JP Morgan Asset Management research, on a global growth basis lower oil prices will generally support growth in the world economy. The investment bank suggests that lower petrol prices have so far reduced the world’s total fuel costs by $1.8bn a day, while estimates of growth suggest that a $10 fall in oil means that major consuming economies will grow by an additional 0.5pc a year at the expense of the major oil-exporting nations.
Although Opec’s most influential members, such as Saudi and the United Arab Emirates, have some of the lowest production costs in the world, they are also the big spenders and also vulnerable to falling prices.
However, years of accumulating vast foreign currency assets should provide their economies with enough insulation. The same cannot be said for emerging nations and Russia.
“Should lower oil prices persist then emerging economies such as Venezuela or Russia may be forced to adjust their fiscal balances by cutting subsidies and social benefit programmes which may trigger political and economic instability,” said Mr Dryden.
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