mathbabe

Having written a couple of guest posts about bubbles possibly inflating (college tuition, high end Manhattan condos), I thought it might be interesting to consider what a deflating bubble looks like.

A number of observers point to the oil markets, where the price of crude has fallen by about 30% since June of this year, to a multi-year low today of about $75.50 per barrel.   Just last spring, Bloomberg was reporting on how the drilling and exploration business in the US was heavily dependent on the issuance of junk rated debt – over $160 billion worth by some measures – to fund the shale drilling that has been so popular lately.  The junk debt had been popular because it was a source of relatively cheap funds, thanks in part to the Federal Reserve’s efforts with Quantitative Easing to drive down bond yields.   Oil and shale exploration are expensive and there are quite a few people that believe that certain types of exploration only make economic sense when the price of oil is above a certain level – say $80 a barrel (or perhaps even higher).  Now that the price of oil has plummeted, there is a possibility that a whole collection of oil drillings and mines are underwater, so to speak, and no longer profitable.

Funding a bunch of expensive exploration with junk bonds makes things complicated and speculative.  For instance, a substantial portion of these junk offerings were purchased by issuers of collateralized loan obligations (CLO) and then rated (up to the AAA level), securitized and distributed to an audience of investors who may or may not have been investing in energy related debt otherwise.  CLOs are being issued at a record pace, by the way, and 2014 is on track to be the highest issuance year ever, exceeding the pre-crisis peak in 2007 of $93 billion.  If the energy exploration companies that issued junk debt are no longer profitable and getting squeezed by the falling price of oil, will that lead to a bunch of companies defaulting and then sending shockwaves through the securitized market, via CLOs?  (Note – the CLO market is much smaller than the subprime mortgage backed collateralized debt obligation market got to be before the 2007 implosion and energy companies are only a portion of the total issuance).

One thing that happens when investable asset prices fall, is that a bunch of people think that maybe it means there’s a new buying opportunity – a chance to get a hot asset at a cheap price on the expectation that prices will spring back up again soon.  That’s what a bunch of hedge funds did a couple of weeks ago, betting that the sharp fall in oil would turn around.  And then it fell another 6 or 7% to today’s levels.   If oil prices continue to fall, as some speculate may happen, that would be called “catching a falling knife” and the investors may end up feeling rather burned by their optimism.  Once cut by the falling knife, some investors become reluctant to come back a re-test their theory on rising prices, and this can contribute to a negative spiral for the falling asset.

I learned from my father-in-law, who worked at an oil company his whole life until he retired, that the oil business is always complicated.  Up and down, supply and demand; they don’t work the way you’d think they would.  When oil prices go down, gasoline gets cheaper, so people drive more, which drives prices back up (unless people are driving less and buying fewer cars, as appears to be happening now, perhaps because of those darn millennials and their urbanization and bike riding).  Plus, there’s international politics, with Russian, OPEC, the Middle East, China the drive for energy independence, solar power, etc.  On the other hand, gasoline and home heating oil and such are getting cheaper, which is a nice bonus for consumers, particularly in more car dependent regions.  The economy benefits from the effect of extra money in the hands of consumers as that money gets spent elsewhere (other than on oil executives third or fourth homes, presumably). Oil is complicated.

But oil can and does crash.  When it does, it can have a wider adverse impact on local oil-dependent economies, like Texas in the 80’s or perhaps, North Dakota, today.  While there are a number of mysterious factors at play in the current fall in oil prices, the knock-on effects are starting to pile up.  Oil producers are cutting production, idling rigs and cutting prices to stay competitive.  The somewhat worried sounding consensus is that there is “too much oil supply” currently. The speculative portion of the oil market will be hit hardest, i.e. the junk-debt fueled shale companies.  At some point, investors in the CLOs (and regular debt) backed by this highly leveraged debt from companies that aren’t profitable anymore, are going to get nervous (yields on such debt are already quite a bit higher) and start selling.  In all likelihood, some exploration companies will fail.  I wouldn’t describe it as a fear environment yet – in many cases the junk debt from exploration companies doesn’t come due for a few years – but the seeds of worry have been planted on fertile ground.  One observer described the current environment as a “negative bubble”, with a herd mentality driving investors away from any optimistic assumptions for the market.

Why should we care?  For most consumers, the most likely impact of a continuing deflation in oil prices will, as I mentioned, be cheaper gas and heating costs.  When the housing market crashed, the negative impact was mostly felt by average Americans, as wealth was destroyed up and down the block, whereas the oil market seems very different and more removed.  Still, it’s fascinating and instructive to watch the dynamics of a (potential) collapse of a bubble – on exploration, shale, oil prices, international politics – and the odds are high for unexpected consequences and global volatility.  What will happen to the recent growth in solar and other renewable energies, if the price of the competing product gets much cheaper?  What about the local politics of fracking? What kind of exposure do banks have to the oil markets and will it trigger any regulatory issues?  What will happen to the international politicians, who like moving chess pieces around the Middle East map if oil-producing countries lose their political clout?  Also, it’s odd that the Fed’s efforts to fight deflation have contributed, in part, to a price collapse of a crucial commodity, via QE-fueled easy money helping to push oil producers to dig up too much oil? How will the Fed react to this challenge?

I don’t know the answer, nor do I expect anyone else does either.   But oil and energy are hugely important issues to most Americans (and the people of other countries, too, obviously) and to the national and global economies – not as big as housing, but pretty close.  What happens in the next few months may affect many of us and it bears watching how our regulators, politicians, mega-companies and generals respond to the emerging (potential) collapse.