The Next Economic Collapse

The next economic collapse has begun. An explanation of how the next oil price crash is going to tank the whole economy

The next financial crisis has already begun.

The following is based on what I’ve read in the news and my understanding of the banking and the oil industry. Maybe reading this can help you prevent yourself from being financially ruined, or perhaps, even capitalize on the coming downturn.

The seeds of the next recession have been sowed and the pale rider is the upcoming crash in the price of oil. The pale rider of the next crash was the “magic” price of $50. You might ask how rising prices, from historic lows in the $26 range early in 2016, could signal the beginning of the true final plunge. Well it’s quite simple. $50 was the price that US companies were waiting for to begin drilling again. Look at the news. People are calling an end to the downturn. It was the price that many companies felt would signal the end of the downturn and the beginning of the next boom. A price that they could comfortably begin to make money at drilling in US tight oil formations and in ultra-deep fields. But alas, $50 oil was a red herring for the end of the slump. The true end is the destruction or shuttering of anywhere from 3 million barrels of production (mbpd) to 5 mbpd of production. That has not happened…yet.

               There has been no significant decrease in production, globally, since the price of oil hit below $27. There have been temporary outages in Canada, in Nigeria and in Libya, but no significant production has been brought offline permanently. Yes Venezuela, and Libyan production has been teetering on collapse, but increased production in Iraq and Iran have more than offset this decline. The decline in US oil production has not been as severe as forecasted, and the rigs have begun to appear back in the fields.  These temporary reductions, and non-completion of wells in the US, have only served to temporary buoy the price of oil and ultimately make the eventual crash much bigger and badder. Everyone has to drill now to survive: the Russians, the Saudis, the Iranians, the Libyans, the Venezuelans, the debt distressed US oil companies and every other oil producer on the planet. It has come to the final reckoning for all of these parties. It is time to drill or to die. But this increase in drilling will only serve to further the glut and bring prices even lower.  

               The news say there have been drawdowns for the last few weeks of US inventory. That is true but what they don’t say is that the drawdown is just of crude, and not of petroleum products. Even this week we saw a build in petroleum products. The last few weeks have seen a predominant increase in petroleum products. They are just moving the crude from one hand to another trying to keep prices high. But these petroleum products inventories are maxing out and their glut is going to cause the final collapse of the spot price of oil and herald in the next economic crash.

               The mechanism of economic destruction, brought on by the upcoming oil price deep dive, is a financial activity that many people have heard of but very few people really understand-the hedge. With prices in the $40s range, and up to nearly $50, the Exploration and Production companies (E&P) (the people who find and bring oil to market) went out and hedged production. That means that even if the price of oil drops to $10 dollars a barrel they still will get paid the price they hedged, or sold, future production at. To help illustrate this activity I will provide a very simple example of a hedge.

               If you are an E&P company, and you want to minimize the risk of future price volatility, you can contract with another party to sell future barrels of oil at a set price. Let us say $40. This contract includes a settlement month, let’s say December of this year. The party taking the other side of the deal is the counterparty. The E&P company wants to enter in this contract because they think that the price of oil may be less than $40 in December but its cost of producing a barrel of oil is less than $40, say $30. So in December, if the spot price of oil is $25, the E&P company gets $15 a barrel from the counterparty as settlement for the hedge. The counterparty entered into the deal because they were confident that the price of oil would be higher than $40, or they knew some sucker who thought the price of oil would be higher, and they are going to turn around and enter a similar contract with that counterparty and try and squeeze a few cents out per barrel contained in the contract by acting as a broker.

             

The hedging of oil at $40 to $50 dollars is very good for the E&P company but is ultimately very bad for the counterparty and as a result the rest of us. The downturn in the price of oil has been very good for the average individual due to lower energy costs and more spending for retail and restaurants. However, the good times will come to an end when the price of oil goes too low. That is because this upcoming low price is a black swan.

This hedging activity is only going to be as destructive as it potentially could be due to the ballooning of the Over the Counter (OTC) trading markets due to the Frank-Dodd act. The act requires companies to post a dollar of margin (collateral) for every dollar of liability they have due to a financial instrument that qualifies. But only in regulated markets. As a result, rather than post millions, if not billions of dollars in collateral, trading shops moved their business to the OTC market. Banks have stepped into the OTC market as brokers, acting as middlemen and dealing with the regulated exchanges and clearinghouses, but not always requiring their customers to post margin. They offset that risk with other financial instruments, generally Credit Default Swaps (CDS), which are bets against a company by buying insurance that the value of their bonds will go to zero due to bankruptcy. But who are the banks buying the CDSs from?  The road to hell is paved with good intentions.

               No one thought oil would ever go to $10 a barrel again. $20 range was considered out of the question. As such there are companies who have not adequately prepared for the distress this price will cause them. This is the same over-confidence that caused everyone to go bust in the housing crisis. “The entire US housing market will never go down all at once”, then that black swan landed and the rest is literally history. Banks have put themselves in the middle of all these hedge transactions, extending huge amounts of collateral, and “insuring themselves” through Credit Default Swaps (CDSs). Well, just like a chain, the financial industry is only as strong as the weakest link. There is another Lehman Brothers out there. Or an even bigger or weaker link.

               When the price of oil goes down to $10, which it very well may, then there will be collateral calls and financial institutions will not have the money to meet those calls. The companies who wrote the Credit Default Swaps will not be able to honor them. Banks, acting as brokers, will be stuck with huge losses and huge liabilities. The Federal Reserve won’t be able to step in, like they did in the last crash, because of changes in regulations set down after the last bailouts of our “too big to fail” companies.

               I tried to read the financial statements of some of our largest banks to see where the above risk was disclosed or quantified. I couldn’t. From what I can glean the at risk positions are definitely 10s of billions if not potentially 100’s of billions of dollars. Maybe even trillions across the entire financial industry. Due to netting, (matching assets to liabilities), for assumed similar financial instruments, you cannot determine the gross amount unless you had access to their data. The idea behind the netting is that both your counterparties will be able to meet their obligations. When push comes to shove I doubt this will happen and companies will have huge losses due to counterparty default. Part of the results of the Frank Dodd Act and the move out of clearinghouses and into the Over the Counter Market.

               The only thing that might prevent this doomsday scenario is a geopolitical event, such as a war between oil producing nations. A sudden, severe decrease in production is the only item that can stop the above from occurring.