The $5 Trillion Oil Debt Bomb

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The drop in the price of oil from approximately $100 a barrel to the $40–60 range roughly constitutes a 40% decline or more.

That’s extreme.

That’s only happened three times in the past 70 years.

Oil and other commodities are volatile, but don’t think for one minute that this is a normal fluctuation.

It’s not. This would be like an 8,000 point drop on the Dow.

When the oil price dropped it came as a shock. No one expected it, other than maybe a handful of people who were plotting it behind the scenes.

When the price of oil goes from US$100 to US$60, which as I said is extreme, people say, ‘Now it’s going to go to US$50, then it’s going to go to US$40 and then, soon after, to US$30.’

You can’t rule anything out, but it does look as if oil is going to oscillate around US$60. It will go above that and below, but it will gravitate towards US$60. That’s still a big deal and will cause a lot of damage.

Why do I say $60? It’s not because I think I’m smarter than a lot of other analysts. I don’t have a crystal ball, either. But I did have the opportunity to speak to various people in the industry, and US$60 is the number they’re expecting.

The oil price didn’t drop out of the blue.

Obviously, Saudi Arabia is the marginal supplier. They can dial up the supply or dial it down. They’re well aware of what’s going on in the rest of the world.

Thanks to the ‘fracking’ revolution in the US, they saw that the US is now the world’s largest energy producer and is close to becoming a net oil exporter.

Yet, even if we give the US credit for being stronger than some other economies, there’s no question about the global slowdown.

Therefore, Saudi Arabia sees demand slowing down. But the question is, how much lower, and what does Saudi Arabia want to do about it?

If they can’t make fracking go away, they at least want to bankrupt a lot of the fracking companies and make them slam on the brakes.

To do that, Saudi Arabia wants to get the price low enough to hurt the relatively higher cost fracking industry.

The power of Saudi Arabia comes from the fact that they have the lowest marginal cost of producing oil.

It only costs them a couple of bucks to lift the oil out of the ground. That oil was discovered, explored and drilled when their entire infrastructure was put in place decades ago.

Because their marginal cost of production is just a few dollars, they can still make money — even at US$40 and US$30 per barrel.

Obviously, the lower the oil price, the more money that’s taken out of Saudi Arabia’s profit.

In theory, there’s a number that’s low enough to hurt the frackers, but high enough so that Saudi Arabia still maximises their revenues.

It’s called an optimisation or a linear programming problem.

That number, which comes from a very good source, is about US$60 a barrel.

It’s not a number I made up or pulled out of a hat. Think of US$60 per barrel as the sweet spot where we have all the bad things in terms of fracking — corporate bonds and junk bond defaults — but not so low that the Arabs hurt themselves more than necessary.

Oil below US$60 is more than low enough to do an enormous amount of damage in financial markets.

Losses are already all over the place. We’re only starting to learn about them right now.

But I guarantee there are major losers out there and they’re going to start to merge and crop up in unexpected places.

The first place losses will appear are in junk bonds. There are about US$5.4 trillion — that’s trillion — of costs incurred in the last five years for exploration drilling and infrastructure in the alternative energy sector.

When I say alternative I mean in the fracking sector.

A lot of it’s in the Bakken and North Dakota but also in Texas and Pennsylvania. That’s a lot of money. It’s been largely financed with corporate and bank debt.

When many oil producers went for loans, the industry’s models showed oil prices between US$80 and US$150.

US$80 is the low end for maybe the most efficient projects, and US$150 is of course the high end.

But no oil company went out and borrowed money on the assumption that they could make money at US$50 a barrel.

So suddenly, there’s a bunch of debt out there that producers will not be able to pay back with the money they make at US$50 a barrel. That means those debts will need to be written off. How much? That’s a little bit more speculative.

I think maybe 50% of it has to be written off. But let’s be conservative and assume only 20% will be written-off.

That’s a trillion dollars of losses that have not been absorbed or been priced into the market.

Go back to 2007. The total amount of subprime and Alt-A loans was about US$1 trillion. The losses in that sector ticked well above 20%. There, you had a US$1 trillion market with $200 billion of losses.

Here we’re talking about a US$5 trillion market with US$1 trillion of losses from unpaid debt — not counting derivatives.

This fiasco is bigger than the subprime crisis that took down the economy in 2007.

I’m not saying we’re going to have another panic of that magnitude tomorrow; I’m just trying to make the point that the losses are already out there.

Even at US$60 per barrel the losses are significantly larger than the subprime meltdown of 2007. We’re looking at a disaster. 

On top of those bad loans, there are derivatives

Some of these fracking companies are going to go bankrupt. That means you may have equity losses on some of the companies if they didn’t hedge. Then, many frackers issued debt which is going to default.

That debt, whether it’s bank debt or junk bond debt, is going to default.

Some other companies are going to be fine because they bought the derivatives. But then, the question is: Where did those derivatives go? Think back to the housing bust. We now know that a lot of the derivatives ended up at AIG.

AIG was a 100-year-old traditional insurance company who knew that they were betting that house prices would not go down. Goldman Sachs and a lot of other institutions were taking that bet too. When house prices did go down, everyone turned to AIG and said: ‘Hey, pay me.’

But AIG of course couldn’t pay and had to be bailed out by the US government to the tune of over US$100 billion. That’s the kind of thing we’re looking at now. These bets are all over the place, because nobody thought oil was going to go to US$60 or lower.

The losses are going to start to roll in, but they’ll come in slowly.

I’m not suggesting that tomorrow morning we’re going to wake up and find the financial system collapsed. This is just the beginning of a disaster.

The first companies to be hardest hit will be second tier or mid-tier drilling and exploration companies.

Don’t worry about the big companies. Exxon Mobil is not going go bankrupt.

But the smaller, higher cost producers with lots of debt will.

With oil in the US$45–55 per barrel range, those projects are no longer profitable and that debt will begin to default in late 2015 or early 2016.

The oil price decline is due to a weakening global economy.

Global demand is slowing down. China is crashing. Japan fell off a cliff in the past six months. Europe is slowing down.

Weak global demand for oil means prices are unlikely to regain past heights.

Investors shouldn’t assume a return to $100 oil anytime soon.

Regards,

Jim Rickards
Strategist, Strategic Intelligence

Jim Rickards
James G. Rickards is the editor of Strategic Intelligence, the newest newsletter from Port Phillip Publishing. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.
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