The sliding oil price could be the next subprime crisis

When investors are ‘reaching for yield’, it’s a sure-fire warning sign.

It’s something that financial historian Russell Napier highlights in his interview with Merryn Somerset Webb this week (watch it here if you haven’t already).

Past experience shows that when investors get desperate, they’ll start lending money to any old enterprise with a good story, as long as it promises some sort of ‘real’ return.

When investors become that indiscriminate about where they put their money, you can be sure that something will happen to burst their bubble sooner or later.

And the an oil price crash might just be the thing to do it.

Investors have been lending rather too freely to high-risk companies

It’s been a great few years for ‘junk bonds’. As the name suggests, this is the risky end of the bond market.

If you buy an investment-grade bond, the main concern on your mind will be prospects for inflation and interest rates over the period of the loan. The chance you might not get your money back is certainly a consideration, but it’s one of several. You’ll be more worried about the return on your money, than the return of your money.

But if you buy a junk bond, it’s very different. The main question should be: what are the chances that this company will default?

The thing is, investors seem to have been getting a little too relaxed about that question in recent years. Low interest rates and the hunt for yield have made it incredibly easy for all sorts of companies and countries to raise money at levels they would never have once dared dreamed of.

Of course, because interest rates have been low, it’s been easy for most companies to service their debt. So default rates are historically low too.

And as always happens, investors have looked at the low default rate, and assumed that this pleasant situation will continue forever – or for at least as long as their investment time-horizon is.

So if a group of companies start going bust rather more rapidly than anyone expects, junk bond investors will be in for a nasty shock.

And that looks rather like what might happen in the energy sector right now.

How the falling oil price could trigger a wave of defaults in the US

Yesterday, the oil price collapsed. Oil cartel Opec – as we discussed earlier this week – decided not to cut oil production, despite the fact that oil prices have plunged by around 30% since June.

There are all sorts of reasons behind the decision. But it’s at least partly a game of chicken. It’s all about seeing who goes bust first – Opec or their new rivals on the block, the US shale oil producers.

The problem for Opec is that many oil producers will keep pumping regardless of profitability, simply to maintain some cashflow. So while there may be a floor to the oil price, it could be quite a bit lower than where it is today.

So as a consumer of oil-related products, I’m quite happy with this state of affairs. However, I’d be getting a little worried if I’d loaned money to the energy sector.

As the Financial Times reports, “massive investment by oil drillers and exploration companies in US energy and shale gas projects in recent years has been partly financed via cheap borrowing conditions across capital markets.”

Ten years ago, ‘energy debt’ accounted for 4% of the US junk bond market. Now it’s up to 16%.

The crash in oil prices has not gone unnoticed. The average yield on junk energy bonds has risen sharply (in other words, prices have fallen) compared to other junk bonds.

“Nearly a third” of that energy-related debt is now “trading so poorly, it currently qualifies as being classed as ‘distressed’, indicating a high likelihood of being restructured.” As Deutsche Bank put it, the tanking oil price “could potentially deliver a volatility shock large enough to trigger the next wave of defaults”.

Could this have a knock-on effect? Given that many areas of the market – including stocks – are historically overvalued, and bond market liquidity in general is being questioned (we’ll come back to this next week some time), I wouldn’t bet against it. Banks are also sitting on some loans that now can’t be sold on to the wider market.

Subprime should have taught everyone that panic in one area of the market can rapidly spread to apparently unrelated ones, as the scramble for liquidity sees even quality assets being sold off.

As one credit trader tells the FT: “Equities ignore at their peril what is happening in the junk bond markets. We have had a long run in credit and slowly but surely, when things turn it starts in the weakest part of the market”.

It’s certainly one reason to continue to be wary of overpriced US stocks.

The beneficiaries from an oil price crash

All the same, there are plenty of winners from a sliding oil price. As David Fuller notes on, this slide comes at a particularly good time for India.

My colleague Matthew Partridge looked at some of the best opportunities for investors in India in MoneyWeek magazine earlier this month. Subscribers can read his piece here. Not already a subscriber? Get a free trial and your first four issues free here.

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  • Darren Turner

    Investors are starting to see that the “Emperor has no clothes” when it comes to shale oil or gas as an investment. This expensive energy can’t be afforded by consumers without causing recession. At non-recessionary oil or gas prices it is loss making for producers. Not to mention the as yet uncosted price of polution to the wider economy and communities. Begs the question why you guys at Moneyweek have been pushing the “Invest in Shale Gas agenda” recently?

    • Trevor Clark

      Then there are the two other possibilities, Darren Turner… (i) you’re an ill-informed, blithering idiot (reference your ridiculous assertion: “This expensive energy can’t be afforded by consumers without causing recession.”); or (ii) you’re directly or indirectly in the pay of vested interests such as Putin, who know that their economies are soon to be destroyed by a dynamic shale gas and oil industry in the UK that will transform our own economy, as its equivalent has done already in several US states. Personally, I’d go with the former. iGas, incidentally, is amongst the very best investments on the planet right now – in my opinion.

      • Darren Turner

        Let’s see how those “transformed” economies perform with oil around or even below $60 for a year. Then we’ll see who is the blthering idiot. Base your argument on facts rather than rhetoric. There has been no growth other than dangerous debt fuelled growth. Asset bubbles blown by 350 year unprecedented free money and money printing hardly indicate a healthy capitalist free market. That market is rigged and drunk on central bank free money. Banks and pension funds are stuffed full of dodgy Energy Sector junk bonds. Look at real facts, US Shale Energy companies have poor or negative free cashflow, that is cash generated from operating incomes minus expenditures. That is the situation at even recent four year long $100 oil . Just imagine their cashflow situation with $60 oil, Like any Ponzi Scheme, this Shale oil and gas sector is bust without constant inflows of new investors to prop it up. Very soon now it will be seen that the Emporer has no clothes. Serious established profit making energy companies like Shell and Exxon have gotten
        out in most plays some time ago because it makes no economic sense at prices the
        economy can function on. I’m all for arguments based on logic and facts, but hiss boo PM question time style doesn’t cut it with me I’m afraid. Please try harder.

    • oh please, US oil production has risen 1 million barrels per day PER YEAR for the past 3 years. That’s not an “emperor with no clothes.” Yeah, it’s capital intensive & justified at higher prices, but why the Malthusian bullshit?? $100 oil was tolerated by consumers despite the crappy Obama economy. And to confuse the issue with pollution??

      The real problem for the economy is the “hollowing-out” of our industrial base for 2 decades which has put consumer incomes and oil prices under pressure. Only rising debt levels have papered-over this problem.

  • Rear Admiral Sir Vincent Smyth

    Cameron has one real choice now. With deflation due by February, will he sanction more QE or go into the election deflating like a popped balloon?