OIL GOES BACK TO THE FUTURE
The collapse in oil prices is positive for most of the world, but will cause recessions in several oil producing countries and defaults in many US oil company bonds. Specifically:
- Defaults on sovereign debt will be painful for bondholders but not big enough to shake global credit markets.
- Defaults on junk bonds issued by US high-cost oil producers may trigger a global slide in junk bonds, and US banks with large loans to oil producers will need Federal assistance.
- Lower oil prices are a net positive for most of the world (e.g. the US, the EU, China, Japan, India), but not for Australia: our next recession is getting closer and deeper.
The movie “Back to the Future” was released in July 1985 and became the highest grossing film of the year. At the same time Saudi Arabia was deciding that it would no longer restrict its oil production so that other OPEC members could benefit from high prices; in late 1985 it began to lift its production from 2 million barrels per day (b/d) to 5 million. As a result, oil prices fell from an average of USD 26.50 in 1985 to a low of USD 11.00 in July 1986.
What we are seeing now in oil markets is a re-run of 1985-86. Saudi Arabia has gotten tired of asking other OPEC members to reduce their production for the long term good of all, and has instead explained its argument more forcefully by pumping more of its own oil. As a result oil prices have fallen from USD 115 in June to below USD 60 now. Lower oil prices create some short-term pain for Saudi Arabia and its allies the Gulf states, but they also reinforce the long term objectives of eliminating marginal producers and discouraging the use of cheaper energy substitutes.
We expect that 2015 and 2016 will bring the same consequences as the 1986 price collapse did. Oil and gas companies around the world will find themselves in difficulties if they have high production costs or high debt levels. Oil producing countries will find themselves in difficulties if they have high production costs, large populations or high foreign debt levels. Banks and bondholders who have lent to these sorts of companies and countries are currently trying to figure out just how many of their loans are going to go bad.
The news spotlight has focused on high-cost oil producers such as Russia, Venezuela, Nigeria and Iran. These countries certainly face recession and turmoil, but their economic problems really aren’t big enough to affect the rest of the world. The economy of Russia, for example, is roughly the same size as California or Italy or Brazil – USD 2 trillion or so. By comparison, the US has GDP of USD 17 trillion, the EU also USD 17 trillion, China USD 9 trillion, Japan USD 6 trillion, and Australia USD 1.6 trillion. The GDP of Iran, Nigeria and Venezuela are all in the range USD 0.6 to 0.4 trillion.
Some commentators have pointed out the similarities with the 1998 Asian financial crisis, but we think that the differences are much greater. Foreign exchange rates are now floating rather than fixed, and most Asian countries learned from the previous crisis that they needed to hold substantial reserves of foreign currencies.
One similarity with 1998 is worth noting. When, say, the Russian ruble is falling, its decline will overshoot fair value and the central bank will sell some of its gold and hard currency reserves. This behavior has nothing to do with economic fundamentals. It occurs because influential persons (“oligarchs”) insist on getting their money out of the country, and the central bank must satisfy them.
Defaults in sovereign debt will be painful for the holders of these debts, but the size of the problem is not big enough by itself to cause another GFC. Most sovereign debt issued since the GFCs has taken the form of bonds rather than bank loans, so the risks are located in professional investors’ portfolios rather than on the balance sheets of systemically important banks. The problems will be most severe for bonds denominated in USD, because the USD is rising against most other currencies. This set of problems has occurred several times since the 1970s as well as in 1998, and it requires painful adjustments for the affected countries, but has little impact on the rest of the world.
Corporate debt in the US, on the other hand, is large enough to cause systemic risk. Energy producers around the world have raised USD 550 billion in investment-grade and non-investment-grade (“junk”) bonds since the GFC: the investment-grade issuers are unlikely to default, but for junk bonds the 1985-86 experience suggests default rates around 15%. According to Barclays, energy bonds now make up 15.7% of the USD 1.3 trillion junk bond market, i.e. USD 204 billion. A 15% default rate implies USD 31 billion in defaults – nowhere near enough to cause another GFC, but very painful for the bondholders.
The companies which face the biggest risk are the high cost US producers, who are predominantly located in the “energy” US states of the central US, from Texas to North Dakota. In addition to issuing junk bonds, many of these companies have also borrowed from local banks. The geographical concentration also repeats the 1985-86 experience, where small banks in the “energy” states had made large loans to local oil companies. The systemic risk will flow from multiple insolvencies among these small banks, but also from the fact that larger US banks have similar exposures to the same bad loans. US authorities will intervene to arrange workouts, and the assets of the troubled companies will be sold off to cash-rich investors such as the oil majors and private equity funds.
What does the fall in oil prices mean for Australia? Like the impact on the world in general, the benefits will be widely enjoyed in small quantities, but the pain will be concentrated in a few sectors. The media’s focus on noise rather than substance means that the publicity given to a handful of insolvencies, layoffs and plant closures will drown out the positive effects of lower oil prices on millions of consumers. Australian banks have relatively little exposure to the energy sector, and almost all of that is to high-quality companies. In the oil sector, the survival of the leading companies is not threatened, but dozens of speculative explorers will run out of money and be re-purposed into dotcoms, biotechs and other exciting new opportunities.
The current oil price collapse completely reinforces our long-held view that the aftermath of the resources boom will be far worse than anyone expects. Oil has now joined coal and iron ore as industries which see plant closures, layoffs and capex cancellations. The slide in mining and oil investment will worsen, and the laid-off workers will come back from the North West Shelf, the Pilbara and central Queensland to find that there are no jobs in Sydney, Melbourne or Brisbane either. The recession which we have long forecast has just got a little closer and a little deeper.
Q.E.D
