Remember the global financial crisis, triggered six years ago when billions of dollars of dodgy loans - doled out by banks to subprime borrowers and then resold numerous times on international debt markets - began to unravel and default?
Stock markets plunged, banks collapsed and the entire global financial system teetered on the brink of catastrophe. Well a similarly chilling economic scenario could be set off by the current collapse in oil prices.
Based on recent stress tests of subprime borrowers in the energy sector in the US produced by Deutsche Bank, should the price of US crude fall by a further 20pc to $60 per barrel, it could result in up to a 30pc default rate among B and CCC rated high-yield US borrowers in the industry. West Texas Intermediate crude is currently trading at multi-year lows of around $75 per barrel, down from $107 per barrel in June.
“A shock of that magnitude could be sufficient to trigger a broader high-yield market default cycle, if materialised,” warn Deutsche strategists Oleg Melentyev and Daniel Sorid in their report.
Five years ago at the beginning of what has become known as the US shale oil revolution, drillers started to load up on debt to fund their operations and acquire new acreage as vast areas of North America started to open up for exploration.
In 2010, energy and materials companies made up just 18pc of the US high-yield index – which tracks sub-investment grade borrowers – but today they account for 29pc of the measure after drilling firms spent the past five years borrowing heavily to underwrite the operations. The result of this debt splurge has been a spectacular rise in US oil and gas output.
Latest estimates suggest that by the end of the decade the US will have outstripped even Saudi Arabia and Russia in terms of oil production. The development of new shale resources in North America and the opening up of fields in the Arctic seas off Alaska could see the country pumping 14.2m barrels per day (bpd) of oil and petroleum liquids by 2020, up from 7.5m bpd in 2013.
This rush to pump more oil in the US has created a dangerous debt bubble in a notoriously volatile segment of corporate credit markets, which could pose a wider systemic risk in the world’s biggest economy. By encouraging ever more drilling in pursuit of lower oil prices, the US Department of Energy has unleashed a potential economic monster and pitched these heavily debt-laden shale oil drilling companies into an impossible battle for market share against some of the world’s most powerful low-cost producers in the Organisation of Petroleum Exporting Countries (Opec).
It’s a battle the US oil fracking companies won’t win.
The problem is that much of America’s shale oil is expensive to produce and the industry is comprised of numerous small companies who were forced to leverage their operations with debt to fund the high cost of drilling wells through a process known as hydraulic fracturing, or fracking. Should oil prices fall for a prolonged period of time many who have been forced to borrow at a higher rate could be forced out of business and ultimately default.
According to research from JP Morgan Asset Management, of the 12 largest shale oil basins in the US, 80pc are barely profitable, with prices of oil below $80 per barrel. More worrying is that these projections don’t include interest payments on debt made by shale producers.
“These guys have taken on a lot of debt to fuel their operations in the US,” said Alex Dryden, an analyst at JP Morgan Asset Management. “As the oil price has fallen we have started to see a sell-off in debt and equities in this energy space in the last few months.”
According to Mr Dryden, the market has become increasingly concerned about the risks of US shale drillers being caught up in an oil price war with members of the Organisation of Petroleum Exporting Countries (Opec). He argues this has already been reflected recently in the US high-yield index and the increasing cost of insuring US high-yield assets in the shale oil industry.
Rig counts also suggest that US drillers are beginning to feel the pinch.
According to Baker Hughes, the number of rigs targeting shale oil in the US fell to the lowest level since August this week. Drilling companies in the massive Eagle Ford shale area of Texas shut down rigs at the fastest rate.
Although senior policymakers within Opec, including Saudi Arabia’s oil minister, have rejected the claim that the group is willing to absorb lower oil prices for the foreseeable future in order to squeeze US producers and Russia to win back market share, many analysts remain suspicious of the reasons why it has not already decided to cut its production target below its current ceiling set at 30m bpd of crude.
I am also sceptical of Opec's unwillingness to act.
Credit to The Telegraph
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