As oil prices remain low, the benefit for US consumers is obvious. But for oil companies? In the short run, prices running at about the cost of production mean no profits for the year, but in the longer run there is a terrible problem ahead.
That’s because the start-up of so many fracking operations across the US came at a cost, and that cost was financed primarily through junk bonds – high yield securities that demand a hefty interest payment to keep the operation going.
Zero profit means more than hard times – it means default and, in all likelihood, a shut down of many wells. That might not only spike up the price of oil, it is big enough to trigger a huge financial problem.
As we’ve discussed before, there is a reasonable floor somewhere around $80 per barrel for the price of West Texas Intermediate (WTI), the standard benchmark for mid-grade US crude oil. Below that price, expensive fracking operations don’t break even and the wells have to be shut down.
But nothing happens overnight, and we’ve already over-shot the floor to about $78 per barrel WTI. Oil in the US is still pumping strong and will continue now that the sunk costs of starting operations for many wells have already been spent. But that speaks directly to the problem with how many small operators with rights to the various wells obtained financing to get the pumping.
“Junk” bonds are nothing more than debt that has been rated as very speculative, requiring it to be financed at a higher interest rate to offset the risk of default. That’s typically 5.8% more than the US government pays on their bonds, or 580 “basis points”. The principle is that something like that percentage of them will never pay back what they owe, so it all comes out in the wash.
Lately, however, that “spread” over US bonds has been running closer to 400 basis points. Investors are hot for a good interest payment and are willing to take more risk to get it.
Junk Bonds are nothing new, but they used to be only good bonds that soured with time and started to look risky. In 1977, Michael Milken of Drexel wrote the first bond with a “junk” rating at issue – to finance a Texas oil company, no less. The idea was that these could be more profitable than safer “investment grade” bonds if the default rates stayed lower than anticipated. They did – at first, that is, as no one defaults in the first year or two of operations. When it all blew up, Milken wound up in jail – but the market for junk was proven.
That is how small companies with a claim to an oil field still get financing, and it’s been booming along with oil. Of the record $1.3 trillion in junk bonds out there, more than $200 billion or 15.7% is for oil drilling. The companies with the rights to the wells are small operators, hence the risk, but investors haven’t been that wary of the problems. After all, oil isn’t going anywhere, and the high prices we’ve seen in the last years made for a guaranteed profit, right?
Except, of course, for the fact that everyone was doing it. With the price low, now everyone might default at the same time, too.
It seems reasonable that the market will shake out only the weakest players, as the price of oil has to rise as rigs go offline as the funding dries up. The problem is that this all takes time, and the international oil market is full of very patient players. Concern over the low price of oil has driven Russia and Saudi Arabia together for the first time ever, agreeing to do what they can to keep the price up by curbing production.
As the price of oil spiked up, so did the interest rate for oil drilling junk debt, now running 520 basis points. The squeeze has started as many investors suddenly realized that they did, in fact, have a lot of risk in their portfolio.
How will this end? Many predict that it can only end badly, but a lot depends on the oil market. If prices stay low, either because the Saudis are keeping them low or because US producers start flooding the market for as much desperate cash as they can raise, the default rate will be obscene. If that starts happening we can expect oil prices to suddenly spike and stay high.
So what we all need to root for is a decent rise in oil prices, about 15%, because it might stave off a much higher and more permanent rise later. The reasons for that are in the bond market that made it all happen in the first place, but the fate of that market may yet be determined by Saudi Arabia and Russia. It’s all far too interesting for something as fundamental to the economy as the price of oil, but that is how the game is played.