Six months ago, the world was alerted to potential economic trouble when a metaphorical canary was sent into the global economic coal mine. At that time, oil prices soared above $110 a barrel. Now, just a month later, the canary has been retrieved—and tragically, it is no longer alive. This signals ominous times ahead for the economy.
Yesterday, oil prices hovered around $59 a barrel, marking a decline of over 45 percent in just six months. This drastic drop certainly classifies as a market crash and indicates dire consequences on the horizon, especially given that this decline pertains to one of the most vital commodities in the global economy.
The rapid decrease in oil prices is creating chaos in the financing structure that has previously fueled new exploration and production efforts. This situation echoes the unforeseen downturn in housing prices that occurred several years ago, which devastated bank balance sheets.
Do you remember when Lehman Brothers dramatically vanished from the financial scene a little over five years ago? It unleashed a torrent of unforeseen events, as black swans descended upon financial metrics like opportunistic scavengers. Unlikely spread movements became an everyday occurrence. The Reserve Primary Fund, a money market fund, notably “broke the buck,” falling to $0.97 per share—an unprecedented event.
If oil prices fail to rebound above $80 per barrel, we can only envision the chaos that will ensue. The repercussions for capital markets could be catastrophic, causing heavily leveraged investment banks linked to oil to suffer dramatically—much like our metaphorical canary. Let’s delve deeper.
Boom and Bust
Warren Buffett once remarked, “It’s only when the tide goes out that you learn who’s been swimming naked.” Over the last few months, the oil price tide has receded, revealing vulnerabilities in the market.
Capital was borrowed to finance fracked oil wells that can only yield profit when oil prices exceed $75 a barrel. Just as mortgage-backed securities revealed significant malinvestment, the current oil boom and bust cycle has been aggravated by artificially low interest rates, courtesy of the Federal Reserve.
So, what’s the remedy for high prices?
Ironically, high prices themselves are the answer. Elevated prices attract new investments, which can lead to overinvestment and eventual supply gluts. Conversely, low prices can trigger underinvestment, decreasing production and eventually leading to higher prices once again.
The boom and bust cycle for oil can span several decades, whereas for agricultural commodities, it may only take two growing seasons. A season of high prices can quickly yield to a season of overproduction, resulting in price corrections.
However, with the current drop in oil prices, it’s not merely the oil and gas exploration sectors that are in peril—the entire financial structure supporting them appears to be at risk.
Watch Out Below
To gain insight, we turn to David Stockman, former Congressman and Director of the Office of Management and Budget under President Reagan.
“As the WTI market price approaches $50 per barrel,” notes Stockman, “remember that the netback to the producer is considerably lower. For example, in the Bakken, the leading shale oil province, the net income at the well-head is roughly $11 less than WTI. This will drastically reduce cash flow and subsequently cut off the funds necessary for drilling operations.
“The real trouble is brewing in the junk bond market. Wall Street’s underwriting standards have been even more reckless this time compared to the era of toxic mortgage securities. Just six months ago, $900 million worth of junk bonds were sold by CCC rated Rice Energy, a company linked to the Marcellus gas shale trend, which should raise eyebrows.
“These bonds were sold at only 400 basis points above the 10-year Treasury rate, and the offering was four times oversubscribed. Demand for these low-quality securities was over $4 billion, despite Rice Energy’s dismal financial history, including $100 million in cumulative operating cash flow against $1.2 billion in capital expenditures. When the junk bond market collapses, Rice Energy will likely follow suit.
“Rice Energy is not an exception; it exemplifies the entire junk shale Ponzi scheme.”
Things could turn chaotic very quickly. As oil prices dip below $60 a barrel, we must remain vigilant. Brace for what’s coming.
Sincerely,
MN Gordon
for Economic Prism
