Watch Out Below

Six months ago a canary was sent down into the global economic coal mine.  At the time, oil was priced at over $110 a barrel.  Last month they pulled the canary retrieval line back up…the canary was dead.  The economy may be next.

Yesterday, oil’s price sat around $59 a barrel.  That’s down over 45 percent in the last six months.  No doubt, this qualifies as a market crash.  Moreover, since it’s a crash in the global economy’s most essential commodity, it surely signals something wicked this way comes.

The rapid fall in oil price is wreaking havoc upon the paper financing structure that was stimulating new exploration and production.  A similar event, triggered by an unexpected drop in house prices, occurred several years ago.  Bank balance sheets were shredded.

If you recall, when Lehman Brothers vanished from the face of the earth a little over five years ago, black swans relentlessly descended upon the LIBOR like common ravens upon fresh Southern California road kill.  Spread movements that were statistically not possible in a million years, somehow, happened every day.  Money market shares of the Reserve Primary Fund did the impossible…they broke the buck – falling to $0.97 cents a share.

We can only imagine the utter madness that would occur if oil prices do not bounce back to above $80 per barrel.  The damage to capital markets could be explosive.  Investment banks, levered up with oil business debt, could go belly up…like the canary.  Let’s explore…

Boom and Bust

“It’s only when the tide goes out that you learn who’s been swimming naked,” remarked Warren Buffett in the run up to the mortgage debt crisis.  Over the last several months the oil price tide has gone out.  Currently, we are discovering who has been swimming naked.

Money was borrowed to fund fracked oil wells that are only profitable if oil is above $75 a barrel.  Like mortgage backed securities, this is turning out to be yet another instance of gross malinvestment.  Similarly, the boom and bust of the oil price cycle has been exasperated by artificially suppressed interest rates courtesy of the Federal Reserve.

The solution to high prices is what?

Naturally, it’s high prices.  High prices lead to new investment, which leads to over investment…and a supply glut.  So, too, low prices eventually lead to under investment, which leads to decreased production and eventually back to higher prices.

For oil prices, the boom and bust cycle can take several decades.  With agriculture it can take just two grow seasons.  One season of high prices is followed by a season of overproduction…and a price correction.

Yet, with the current oil price crash, it’s not just the oil and gas exploration industry that’s in trouble.  The financial system that’s been propping it up is doomed.

Watch Out Below

For edification we turn to David Stockman, former Congressman and Director of the Office of Management and Budget under President Reagan.

“So as the WTI market price is driven toward $50/ barrel,” notes Stockman, “recall that the netback to the producer is significantly less.  In the case of the biggest shale oil province, the Bakken, the netback to the well-head is upwards of $11 below WTI.  Accordingly, cash flow will plunge and that source of drilling funds will evaporate with it.

“But the big down-leg is coming in the junk market.  This time around, Wall Street has been even more reckless in its underwriting than it was with toxic securitized mortgages.  Barely six months ago it sold $900 million of junk bonds for CCC rated Rice Energy.  The latter operates in the Marcellus gas shale trend but that makes the story even more preposterous.

“These bonds were sold at barely 400 bp over the 10-years treasury, and the issue was 4X oversubscribed.  That is, there was upwards of $4 billion of demand for the bottom of the barrel securities of a shale speculator that had generated the following results during its 15 quarters as a public filer with the SEC.  To wit, it had produced $100 million of cumulative operating cash flow versus $1.2 billion of CapEx.  In short, if the junk bond market dies, Rice Energy is a goner soon thereafter.

“Here’s the thing, however. Rice Energy is not an outlier.  It is a poster child for the entire junk shale Ponzi.”

Things could get ugly real quick.  Oil fell below $60 a barrel yesterday.  Watch out below.

Sincerely,

MN Gordon
for Economic Prism

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