Currently, oil prices are stabilizing around $45 per barrel, and gasoline prices are finally declining as well. This past weekend in sunny California, we managed to fill our tank with gas priced at just $3.19 per gallon—a remarkable bargain.
The interplay of overproduction, slowing global economic growth, and the lifting of sanctions against Iran may keep oil prices suppressed for several years to come. For commuters in Southern California and consumers elsewhere, these lower prices act like a boost to disposable income, allowing the savings at the pump to be redirected toward purchasing other goods.
Typically, reduced oil prices and an uptick in consumption would inherently increase the Federal Reserve’s favorite indicator—aggregate demand. Lower costs for oil could potentially provide a boost to GDP as well as allow consumers to pay down debt.
However, this situation is not a standard cyclical decrease in oil prices. This decline represents a significant bust following a preceding boom in U.S. oil and gas development. Furthermore, many substantial financial commitments were made under the assumption that oil prices would remain significantly above $45 per barrel.
Consistently low oil prices are undermining the financial structures that fueled new oil exploration and production ventures. A similar occurrence happened several years ago when an unexpected drop in housing prices led to widespread financial disarray among banks. Thus, any economic lift from reduced oil prices may be overshadowed by the repercussions of failed oil projects.
Filling the Gap
The core issue lies in the substantial borrowing undertaken to finance fracked oil wells that remain profitable only if oil prices exceed $75 per barrel. Currently, with oil priced at only $45 per barrel, vast swathes of oil wells across Texas and North Dakota are operating at a loss.
This situation has left banks and investment funds worldwide with a portfolio of troubled loans. Much like mortgage-backed securities, this has emerged as another notable example of severe malinvestment. The boom-and-bust cycle in the oil market has been exacerbated by the Federal Reserve’s artificially low interest rates.
In a functioning market, high prices naturally lead to increased investment, which often results in overinvestment and a surplus of supply. The Federal Reserve’s easy credit has pushed this investment to unsustainable levels. Conversely, low prices eventually result in underinvestment, leading to reduced production and, ultimately, a return to higher prices.
The boom-and-bust cycle in the oil industry does not unfold within a single calendar year. Introducing new supply can take decades, and once it is established, it cannot be easily switched off. Although some revenue is better than none, the gap between production costs and revenue needs to be bridged. At $45 per barrel, operators struggle to maintain positive cash flow. The next stage of this downturn will likely see banks tighten or completely withdraw credit from oil producers—a scenario that is approaching quickly.
Oil Debt Bubble Facing Total Collapse
As reported by the Houston Chronicle, next month banks will reassess the credit they extended to oil companies during the period of higher crude prices. This review could lead to a reduction of up to $15 billion in credit lines, further straining an industry that has already laid off thousands of Texas workers and idled numerous drilling rigs. Such cuts could leave companies without the cash needed to survive through low prices while also hampering their ability to secure funding for new exploration as prices eventually rise.
This year has already witnessed 79 corporate defaults, up from 60 for the entire year in 2014. Among these defaults, 24 have occurred within the oil and gas sector. This number is expected to increase dramatically as we approach the end of the year and transition into 2016.
The Energy Information Administration reported on September 18 that a staggering 85 percent of U.S. oil drilling companies’ revenue cash flow—encompassing both major oil companies and smaller shale producers—is being directed toward debt repayments. This is a dramatic rise from a previously steady range of 45-55 percent over the last decade. Clearly, an 85 percent allocation cannot be sustained beyond the early months of 2016.
The total high-yield debt bubble in this sector stands at approximately $600 billion and is being rolled over at rising interest rates of 11-12 percent. It is facing imminent collapse.
Major bank failures are likely to follow this collapse, pushing the economy back into recession. In turn, Federal Reserve Chair Janet Yellen will unveil a grand intervention plan. The effectiveness of modern monetary policy will be severely tested as the once-theoretical concept of “helicopter money” could soon become a reality in your area.
Sincerely,
MN Gordon
for Economic Prism
Return from Oil Debt Bubble Facing Total Collapse to Economic Prism
