Federal regulators fear that collapsing oil prices could endanger highly indebted energy companies and will watch carefully to ensure contagion doesn’t spread through the financial sector.
Falling oil prices will save drivers money at the pump, but also means trouble for smaller energy producers. American energy production will slow if prices stay low, and many companies could default on their debts, raising the possibility of broader financial turmoil.
“It is a very significant concern,” said Mayra Rodriguez Valladares, a financial regulatory consultant with a background in energy finance. “There are a number of people who have understated the effect of this,” she said, suggesting that falling oil prices and volatility overseas could generate a scenario like the one that led to the bailout of the Long-Term Capital Management hedge fund in 1998.
Many of the drilling companies that have led the way in shale regions are small and operate with a high amount of debt compared with capital. They aren’t the oil “majors” like ExxonMobil, which are diversified and boast refining operations. They’re mom-and-pop-type operations, often owning a single oil well and having fairly low credit ratings.
That makes it difficult for those companies to withstand lower oil prices for a sustained period. The effects, however, might not be immediately felt.
“If the prices stay where they are, you’re going to see a lot more defaults in 2016,” said Tom Watters, an oil and gas sector analyst with Standard & Poor’s, a credit-rating agency. He added that many smaller companies “won’t have the wherewithal to reinvest” in wells, which can lose up to 70 percent of production in their first year.
The Bank of England warned Tuesday in its financial stability report that fears about rising risks in the low-grade debt used to finance some shale oil and gas companies could lead to fire sales or illiquidity in the broader trillion-dollar-plus U.S. junk bond market. Federal Reserve Chairwoman Janet Yellen warned this summer that junk bond prices were “stretched.”
Energy-sector junk bonds make up about one-seventh of the U.S. high-yield debt market. Tim Crawmer, a senior investment manager at Aberdeen Asset Management, said current market prices suggest that investors expect defaults on 25 to 30 percent of energy junk bonds over the next three years if the price of oil stays in its current range.
When the price of oil was above $110 a barrel in June, “everyone was willing to give them money,” Crawmer said of U.S. energy producers. Now, he added, “the regulators are a little bit worried about the liquidity in the high-yield market and what would happen if there was a selloff.”
The Organization of Petroleum Exporting Countries, led by Saudi Arabia, decided last month against cutting production that would have boosted prices. U.S. output has soared to a projected 9.3 million barrels next year, according to the U.S. Energy Information Administration, proving a rival to OPEC’s nearly 40 percent global market share.
Prices for Brent crude, an international benchmark, have fallen to five-year lows of below $60 per barrel this week. That has hit some drillers that operate high-cost wells that use hydraulic fracturing, or fracking, in shale regions that have sparked the American energy boom. Many drillers in the most prolific U.S. fields, though, have improved efficiencies through technological advances to stomach a price of between $40 and $50 per barrel.
Firms that operate in marginal shale regions — generally, those outside the Bakken in Montana and North Dakota and the Permian and Eagle Ford in Texas — are feeling the strain. Smaller drillers with high debt-to-cash ratios are particularly vulnerable. So too are companies with few oil reserves or other assets to sell. Companies that provide services to drillers, such as those that prepare wells, would take a hit if drillers scale back spending.
“There’s definite concern about the low oil price,” said Kathleen Sgamma, vice president of government and public affairs with industry group Western Energy Alliance. “And producers that are obviously highly-leveraged or not in the best fields will have a harder time weathering the storm.”
Watters said bond markets for many of those firms have dried up. He suggested there could be reverberations across other sectors.
“I think the high-yield market the last couple years has had a good run. But with the contagion coming on as oil prices drop, yeah, it could spread,” he said.
Companies have delayed capital expenditure plans until early next year to suss out where prices are heading. Drillers will spend 20 percent less than this year on those expenditures, the Moody’s credit-rating agency predicted.
That means U.S. oil output is likely headed for a slowdown later next year, though production is due to increase in the first and second quarters to reflect recently-drilled wells.
As for the short-term effect on financial markets, LPL Financial Senior Vice President of Research Anthony Valeri said investors had gone too far in pricing in a near doubling of defaults.
And while a high amount of debt might be a warning sign for small U.S. oil producers, it’s important to look at the due dates for companies’ debt, said Frederick Lawrence, vice president of economics and international affairs with the Independent Petroleum Association of America.
“A lot of these companies have high debt, but it’s not due for years,” Lawrence said.
The broader threat to the financial system is limited because banks are better capitalized and prepared than they have been in the past.
“You could have a little bit of a repeat of ’98, where a big hedge fund fails, but I think they’ve learned their lesson,” Valeri said of the non-bank financial companies that have financed much of the shale boom.
Instead, analysts suggested, the bigger threat to the financial system might come from outside the U.S. Some cited financial turmoil in Russia and Venezuela as a bigger threat to the U.S. than domestic producers.
An even bigger threat is the possibility that falling oil prices are indicative of a worldwide macroeconomic slowdown.
“The significance of the movement in the price of oil may be more indicative of a significant decrease in demand” that signals economic weakness, said Jamie Farnham, the director of credit research for investment management company TCW Group.
“The U.S. economic data by and large looks relatively good,” Farnham said, but with prices of a number of commodities down 50 percent, “you have to pay attention to that.”
Still, if oil prices were to rebound next year, as many analysts expect, financiers might get back into the game.
“Going into 2015, some of these investors on the sideline maybe will come back into the market and give them support,” said Terry Marshall, senior vice president with Moody’s, though he noted, “It’s really hard to say how long this price environment lasts. Nobody knows.”
