Oil Market Meets Minsky

During the Great Financial Crisis, Hyman Minsky, was rediscovered.  Minsky's insight was that long periods of steadily rising asset prices encourages financial engineering and leveraged bets that assume a continued rise in asset prices.  The so-called Minsky moment comes when the asset prices stop rising and even fall.  The virtuous cycle turns vicious. 

We are now all familiar with how that narrative played out in the housing markets in numerous countries.   The question we pose is whether similar forces are unfolding in the oil market.  

For the past several years, oil prices have averaged the highest on record, even though the 2008 peak near $150 has not been approached.  The high price of oil did two thing.  First, it helped create a mindset that was predisposed to believe we were at peak oil.  That new finds were rare and located in more difficult places to reach.  Second, it helped spur technological advances, and encouraged new production. 

The idea that oil prices were going to continue to trend higher for as far as the eye could see became extremely entrenched, and not just in the oil market.  This was the basis for both conservation and development of alternatives.    Some $90 bln of high yield debt was issued by US energy producers over the past three years.  This effectively doubled the energy sector's share of the high yield bond market.  The ability of borrow was predicated on the value of the oil in the ground.  In addition to the high yield bonds, many banks have provided leveraged loans to the shale producers.   

The leveraged aspect is not limited to the shale producers, but downstream and upstream concerns were also leveraged.  This includes the borrowing of money for railroad cars to ship the oil.  It include the chemicals and other supplies needed for the fracking. 

The precipitous decline in oil prices changes this dynamic.   Many observers seem to be repeating the judgmental mistakes made in late-2007 and early 2008, and not giving enough due to Minsky's insight.  The key is not so much the level of oil prices, but that fact that prices are not rising.  Rising prices was what justified the leverage and capital expenditures.   

The high yield shale sector energy bonds are likely held in by asset managers and hedge funds.  It would not be surprising if some pension funds, endowments and other funds had exposure through their alternative investment allocations, after all, like the housing market, Peak Oil was as story of a life time.  The high yielding energy bonds are off around 13% over the past 5-6 months.  The industry indices that track the sector are off about 2.5% excluding energy.      According to some reports that track fund flows, some $14.2 bln has left high yield funds this year after taking in around $72 bln over the past five years.  

The implication of these developments is that the days of cheap credit to energy sector broadly conceived is over.  This will curtail exploration and new development.  Capacity that has already been funded will come on stream in the coming months,  but new production will be slower coming on line. An industry report cited by Reuters found that permits for drilling new wells, which had doubled in the past year, fell 15% in the month of October (i.e. before the latest leg down in oil prices). 

This is a turning point in the industry.  The shale sector is fragmented.  Its debt acts as a high fixed cost.  These conditions will produce a behavior response similar to what we have seen in other industries when faced with a similar situation.  First, high fixed costs relative to variable costs provide incentives to initially produce even at a loss.  This only aggravates supply driving the decline in prices.  Second, as the high yield bonds and leverage loans become distressed, more provisions will have to be made by the banks, while fund managers will look to reduce exposures.  Third, there will be industry consolidation.  This appears to have already begun with the Halliburton-Baker Hughes tie up and Berkshire Hathaway's purchases in the fracking fluids and chemical space. 

The Peak oil story filtered through many other sectors outside of energy.  High costs for energy encouraged conservation, but as oil prices led to lower gasoline prices, this has changed.  In fact, SUVs and light truck sales helped fuel strong vehicle sales this year.  Data out yesterday indicated that November was the second month since 2006, that Americans bought more than 17 mln vehicles on a seasonally adjusted basis.  August was the other month. 

Last month luxury SUV sales soared.  Purchases of the Cadillac Escalade and the Lincoln Navigator increased by about 90%.  Incidentally, these models are both less energy efficient and higher profit margin (~$10k pre-tax profit per vehicle, according to industry analysts cited by news wires) than smaller vehicles).