Bubble finance, junk energy bonds, oil derivatives being neglected by mainstream media

Those who still think the plummeting price of oil is a good thing for the economy are taken in by PR spin or the simple lack of coverage in the mainstream media. It is not about consumers having lower petrol prices and more in their pocket. It’s not even about the energy. It’s about the money, the financial structure of the oil industry, particularly for the wildly speculative ventures like shale oil extraction. Environmentalists will see low oil prices as bad news for climate change but they need also to look at the way these energy shale firms are financed and learn about things they don’t want to know about, like junk bonds, leveraged loans and derivatives. It causes more immediate pain and must be survived first.

WTI to 12 Dec 2014The relentless slide continues. As of Monday 15 December in New Zealand the price of WTI oil was $56.73, down over 47% since June this year.

Unfortunately in New Zealand we are being shielded from all this bad news. Bubble finance is not a sexy topic for a front page. During the last week the Dominion Post, national radio, Sunday Star Times had nothing, and a business programme on Radio Live on Sunday touched on everything but the junk energy bond issue or the derivative issue. The programme gave the impression the only place to invest was in shares, bonds or fixed interest. When the derivatives market is so enormous, this is a major omission. It’s not as though the media believe the public won’t be able to understand junk energy bonds or derivatives. The corporate owned media only gives us bad news when it is about crime.

OK let’s try and explain it.

There are four major risks of plummeting oil prices
. The first is the risk to junk energy bonds held by pension funds, mutual funds and governments. Second is the secondary oil market, including the risk associated with a variety of oil derivatives contracts held by big banks. The third is the social unrest in oil exporting countries like Venezuela, Russia. And a fourth is the ongoing and contagious decline in prices of a range of other commodities – iron ore, copper, milk powder. Let’s just deal with the first two, though the fourth one is dealt with in passing.

1. Junk energy bonds. What on earth are these, you might ask. They are the risky bonds that energy companies sell to help finance their operations. The bonds give you high returns but they are also high risk as they are unsecured loans. That risk-taking now comes home to roost. For a new venture now the bank will lend you less because the oil in the ground as their security is now worth less. In December 2014 the oil is worth only about half what it was six months ago. So you have to get more of your funding from junk bonds. You end up shelling out more in interest and what’s more you get less in revenue from the sale of your oil.

Michael Snyder says “The impact of lower oil prices has been felt directly by high yield energy bonds and since September they have posted a return of -11.2%. J P Morgan has warned that if oil prices stay at $60 a barrel for three years 40% of the junk bonds could be facing a default.”

Of course other companies finance themselves using junk bonds (as well as bank loans at a low interest rate and their own revenue stream). The energy sector accounts for over 17% of the high yield bond market (junk bonds) and when these are hammered apparently a stock market decline always follows. It’s not a small sector either. Analyst Wolf Richter says there are $210 billion of them.

So they have to sell more bonds. Unfortunately now fewer investors want to buy the risky bonds so that means the yields go up to make it more tempting for investors. As the debt markets dry up and profits fall due to cheaper oil, the funding gap widens.

It was all beautifully explained in October 2014 when oil prices were $85/barrel here

Who loses from this? The investors. And those employed in the oil industry as smaller or more indebted firms are less viable than others. And that is just the start.

But it isn’t only junk energy bonds being affected now. As the Financial Times told us on December 12,
“Investors are fleeing the US junk debt market as a selloff that started in low-rated energy bonds last month has now spread to the broad corporate debt market amid fears of a spike in default rates.” Woops, that wasn’t meant to happen.

2 Oil derivatives. Like other industries over the last few decades of financial wizardry, the oil industry has been financialised.

Remember when housing debt was bundled up by the banks, securitised, divided into tranches according to risk, and sold off? It was to increase the profits of the banks. You just pass the risk on. The bonds are sold to unwary buyers who don’t realise the risk for massive losses. The whole process was enabled by rating agencies who rated junk bonds (the risky ones have high returns) as A++. A great movie explaining all this was The Inside Job.

Now we have version 2 of the same script. Instead of CDOs (Consolidated Debt Obligations) we have got CLOs (Consolidated Loan Obligations) – just a different name this time. It’s what is called ‘leveraged loans.’

The 6 largest ‘too big to fail’ banks control $3.9 trillion in commodity derivatives contracts. A large portion of this is in energy. And the big banks of the world are on the other end of derivative contracts.

One of the headlines of a tweet going round is “Plummeting Oil Prices Could Destroy The Banks That Are Holding Trillions In Commodity Derivatives”

There is nowhere to hide. As the entire global economy is dependent on the six biggest banks, we will all be affected, even in New Zealand.

The Oil Industry is not just any old industry
Writing on Zero Hedge in October when oil was $75/barrel, Michael Snyder explains the huge investment of the energy industry in both capital expenditure and R&D.

He quotes the Perryman group on the economic effects of the oil industry in US alone:
If you think about the role of oil in your life, it is not only the primary source of many of our fuels, but is also critical to our lubricants, chemicals, synthetic fibers, pharmaceuticals, plastics, and many other items we come into contact with every day. The industry supports almost 1.3 million jobs in manufacturing alone and is responsible for almost $1.2 trillion in annual gross domestic product. If you think about the law, accounting, and engineering firms that serve the industry, the pipe, drilling equipment, and other manufactured goods that it requires, and the large payrolls and their effects on consumer spending, you will begin to get a picture of the enormity of the industry.

The combination of junk bonds and financialisation
Putting these two first effects together, former Reagan budget chief David Stockman, in an analysis on his “ContraCorner” website Dec. 9, wrote: “The now-shaking high-yield debt bubble in energy is $500 billion — $300 billion in leveraged loans and $200 billion in junk bonds. This is the same estimate EIR has made in recent briefings, of one-quarter of the $2 trillion high-yield market being junk energy debt. In that junk energy debt market, interest rates have suddenly leaped, in the past 45 days, from about 4% higher than “investment grade” bonds, to 10% higher; that is, credit in that sector has disappeared, triggering the start of defaults of the highly leveraged shale companies and their big-oil sponsors.”

“In the larger, $2 trillion high-yield debt market as a whole, interest rates have also risen sharply, so far by 2-2.5%: i.e., contagion. Whether the debt collapse will be “mini”, or maximum, may be determined in the markets for $20 trillion in commodity derivatives exposure.

“So now we come to the current screaming evidence of bubble finance—–the fact that upwards of $500 billion of junk bonds ($200B) and leveraged loans ($300 B) have surged into the US energy sector over the past decades—–and much of it into the shale oil and gas patch.

“An honest free market would have never delivered up even $50 billion wildly speculative ventures like shale oil extraction million of leveraged capital—let alone $500 billion— at less than 400bps over risk-free treasuries to.”

The simple fact is low oil prices kill millions of jobs. Falling oil prices are dangerous. While readers of mainstream media, listeners to radio and watchers of television remain in blissful ignorance of the nightmares that fund managers are living through, they will celebrate Christmas as though nothing had happened – and then ask later why nobody warned them.

The first Global Financial Crisis came on us with little apparent warning. The Queen was famously known to ask “ Why did nobody see this coming?”

For the last five years since QE, energy companies have received super cheap financing. Quantitative easing, where the Fed created trillions of dollars for banks, was a gift to the capital-intensive energy industry. Moreover job creation has been huge. Bloomberg reports Employment in support services for oil and gas operations has surged 70 percent since the U.S. expansion began in June 2009, while oil and gas extraction payrolls have climbed 34 percent.

It doesn’t matter whether the trigger for this fall was OPEC punishing the shale industry, falling demand in China, the end of QE or what it was. It was going to happen anyway and the trigger might have been anything. The whole pack of cards simply has to tumble. It’s a cauldron of death brought to the boil.

But many have seen it coming – Nicole Foss and Raul Ilargi Meijer of The Automatic Earth, Michael Snyder, Gail Tverberg, Jesse Colombo, Wolf Richter, Yves Smith are a few names that spring to mind. It’s just that haven’t been listened to yet. Whether is it the Tulip Bubble, the South Sea Bubble or the housing bubble of 2007, bubbles have a nasty habit of bursting.

Commodity bubbles, oil derivatives and the price of petrol

This week several questions in Parliament were about the drop in the price of dairy products and the effect on the New Zealand economy. But the price of wool, beef, timber and logs are not dropping. I began wondering about commodity prices.

On the radio I heard a journalist say that if oil prices are down then economic growth rises. He went on to say how well the economy will do now that the price of oil is falling.

That is a deceptive argument. As Automatic Earth blogger Raul Ilargi Meijer pointed out the oil companies are already mired in debt, and when they receive less for their oil their finances will be in real trouble. He says, “there is no industry like the oil industry and it’s highly doubtful there’s another one with such debt levels”. The drop in crude prices has undercut the profitability of many oil projects and if you are an oil-exporting country you are vulnerable. Russia is being hammered right now and the ruble is in freefall. The share market in Saudia Arabia is falling.

Meijer points out that plummeting oil prices don’t just mirror the state of the real economy they will drag the whole economy down. The oil industry swims in debt not reserves.

Remember in 2012 Petrobras pulled out of New Zealand? They said they hadn’t found enough oil. Rather than giving the credit to Greenpeace for their vigorous opposition to deep sea drilling, the company’s explanation about low profitability is probably nearer the truth. Petrobras is the world’s third biggest oil company with sales of $150 billion a year.

The Telegraph writer Ambrose Evans-Pritchard in an article on oil company indebtedness wrote “Petrobras is committed to spending $102bn on development by 2018. It already has $112bn of debt. Petrobras’s share price has fallen by two-thirds since 2010.

This led me back to the whole commodity issue. I found a good article by bubble analyst Jesse Colombo and will summarise it. https://web.archive.org/web/20120302222518/http://www.thebubblebubble.com/commodities-bubble

He says “China’s economic boom since 2009 is actually a debt-driven bubble, and that its unsustainable, resource-intensive growth has temporarily boosted the prices of commodities.” He has been expecting the bubble to burst for a while now.

China’s consumption of commodities drove real money into a new “asset class”. But production has spiked and the bubble is popping now as real money leaves. We are now at the end of the commodities supercycle.

Three years ago the same Jesse Colombo warned of a commodity bubble. He said “The price of nearly every commodity from wheat to uranium exploded during the past decade as hundreds of billions of dollars of capital entered commodities as the new “hot” investment destination.”

He wrote then “Commodities prices, as measured by the Continuous Commodity Index (CCI), have risen a staggering 275% since the start of their bull market in November 2001”

He said Crude oil (WTI) is up 1,050%, gasoline 1,050%, heating oil 1,000%, gold 528%, silver 1130%, copper 666%, platinum 435%, palladium 443%, wheat 275%, corn 348%, soybeans 250%, oats 300%, sugar 600%, coffee 635%, cocoa 435%, orange juice 245%, cotton 650%and lean hogs 213%. (measured at the peak in mid-2011)

“Like all bubbles, from the Roaring Twenties bubble to the Dot-com bubble, the 2000s commodities bubble started as a legitimate economic trend and devolved into a “hot money”-fueled speculative mania.

“Record-high commodities prices led to ambitious plans such as Quebec, Canada’s $80 billion investment and decision to open its vast northern region to mining development – an area twice the size of France with an abundance of iron, nickel and copper ore deposits.

“High oil prices have incentivized the development of a wide range of technologies that are helping the discovery and production of far more oil than originally estimated and helping to allay Peak Oil fears for the time being. Fracking in US made US the biggest oil producer in the world.

“China and India’s real estate development and infrastructure construction soared in the early 2000s, causing economic growth and the demand for raw materials to hit a powerful upward inflection point.

“While the Chinese government builds scores of excessively extravagant government buildings, entire uninhabited “ghost cities” are cropping up, as can be seen in satellite images.

“When China and India’s economic bubbles pop, the commodities bubble is sure to crash along with them.

We have also seen the rise of commodities as an investment class. The boom has taken place across a wide range of commodities, and, indeed, is unprecedented in scope and size. These commodities include sugar, cotton, soybean oil, soybeans, nickel, lead, copper, zinc, tin, wheat, heating oil.

derivatives-3“The unprecedented aspects of the commodities boom and bubble are due to a relatively recent fundamental change in the commodities market – financialization, or the large-scale transformation of the commodities market into an investment asset class like stocks and bonds.

“Pension funds have become one of the largest sources of capital parked in long-term commodity investments ever since Congress essentially forced them to diversify into commodities by law. The tsunami of new investment capital flowing into the commodities market has been a major contributor to the boom in prices. In addition, the financialization of commodities paralleled the financialization of, and bubbles in, the US housing and mortgage markets.

But it is not just the commodities themselves. There is now a staggering range of commodities derivatives products. They call it “financial innovation”. Here is Jesse Colombo again in 2011 “The market value of agriculture commodities derivatives grew from three quarters of a trillion in 2002 to more than $7.5 trillion in 2007, while the percentage of speculators among agriculture commodities traders grew from 15 to 60 percent. The total number of commodities derivatives traded globally increased more than five-fold between2002 and 2008. The commodities market has become increasingly dominated by big banks, hedge funds and other speculative participants.

According to Wikileaks cables, speculators, not supply and demand, were the main cause of the 2008 oil bubble when oil hit $147/barrel.

One of the main catalysts for the second phase of the commodities bubble (2009-to-Present) was the launch of the Federal Reserve’s quantitative easing (QE) programs.”

Further to the topic of derivatives. If you want something scary to read then try reading about how big banks hold a great many oil derivatives and are at the losing end of the bet as oil drops in price. http://www.activistpost.com/2014/12/plummeting-oil-prices-could-destroy.html

And here is an article from earlier this year. The author is one Harry Dent and the website http://economyandmarkets.com/markets/foreign-markets/2014-the-year-china-bubble-burst/ and I quote it in full.

“For two years now, I’ve been warning in our Boom & Bust newsletter that China is going to be the ultimate and largest trigger for the next global financial crisis… a crisis that will be deeper and last longer than the first one that governments quickly combatted with unprecedented quantitative easing and bailouts.

And the cracks in the greatest bubble in modern history are finally starting to show. China bubble burst? Yes. And 2014 is the year that happens. When it does, it will trigger a market crash around the world.

George Soros warned late last year that China’s subprime lending was starting to look like the U.S. just before its crisis.

Now Leland Miller, President of China Beige Book International, is warning that 2014 will be the year of defaults for China.

Defaults will occur in trust products… wealth-management products… corporate bonds… and even some government bonds.

China’s subprime lending has mushroomed to more than $2 trillion in the last five years.
Its corporate bond market now totals $4.2 trillion.

Its total credit has surged from $9 trillion to $23 trillion since late 2008, or 250% of GDP.
Once again, additional borrowing and spending adds very little to GDP…

Just like it was, right before our subprime crisis, right now every dollar of debt China incurs adds only 15 cents to its GDP. At the height of our crisis in 2009, each additional dollar of debt created 85 cents of GDP.

China is currently getting very little bang for its borrowed buck.
As I always say: Debt is like a drug. It takes more and more to create less and less effect until the system fails.

Now, China’s system is starting to fail… and the bubble is starting to blow up and the fallout will affect us all.

As Miller warns, this is a different China than that of the past two decades. The government understands that it has to slow growth after massively overbuilding and inflating bubbles.

This, he warns, will impact China’s neighbors — places like South Korea, Japan, and Australia (where I recently issued strong warnings about the China burst) — more than most people assume.

Societe Generale’s analyst, Albert Edwards, warns: “Australia is a leveraged time bomb waiting to blow up. It is not a CDO (meaning collateralized debt obligation), it is a CDO squared. All we have in Australia is, at its simplest, a credit bubble (consumer debt) built upon a commodity boom, dependent for its sustenance on an even greater credit bubble in China.”


Already, an agricultural financial co-op has closed its doors, and depositors couldn’t withdraw their money. And a China Credit Trust wealth-management product of $496 million blew up.
The Chinese government bailed them out.

Then, on March 7, China saw its first corporate bond default, when Shanghai Chaori Solar defaulted on its bond payments. It’s unlikely the government will bail it out.”