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Trading Lessons

Clearing The Decks For The Crude Oil Subprime Rout

Commodities / Crude Oil Dec 11, 2014 - 12:52 PM GMT

By: Andrew_McKillop

Commodities

The Clown Prince of Overpriced Oil Bows Out
Andy Hall, the celebrated speculator on rising oil prices and related asset values is bowing out. Not long ago, he was still loudly telling the boomers that oil prices would inevitably bounce and could soon hit $150 a barrel, partly due to US shale oil "being a dud". Hall railed at anybody, like me, or Hall's pet hate, Citigroup's Edward L. Morse, who dared to argue that $75 for a barrel of oil is a very reasonable price – in fact a lot more than today's price! US natural gas and world coal, for example, provide energy at around $25 to $30 per barrel equivalent. Is oil really worth that much more? If so, why?


Along with so-called "star broker" firm Phibro, which Hall often worked with and for, both have now bowed out. Both either didn't understand, or didn't want to understand that the commodities and oil boom (and of course "soaring equities"!), in their post-2009 avatar, is a Frankenstein monster of debt, especially in the energy sector. And inside that sector, especially in oil. Debt is the most-dangerous enemy of US shale gas and oil – far worse than oil prices at today's price nearing $60 a barrel. To be sure, further down oil's slippy price slope, greased with debt and finaicial risk, low prices would become the killer-factor. But for now, and perhaps until or unless oil prices hit $50 or less, and stay there, it is energy sector corporate debt and the interest rates paid on it which will call the shots.

Reporting Phibro's effective bankruptcy this week, 'Wall St Journal' said: "the 113-year-old company, founded in Germany by two scrap-metal dealers, is winding down its U.S. operations [such as Citigroup Inc Phibro LLC]  after it failed to find a buyer, according to a person familiar with the situation. The sale process for units in London and Singapore continues, the person said".  UK-born Andy Hall was Phibro's star speculator betting on and for overpriced oil, but everybody's luck on the casino tables runs out, some day.

Neither Phibro nor any other big name broker firm linked with commodities trading, like also-bankrupt MAN Group cared to read the tealeaves, crystal balls or macroeconomic trend studies concerning the post-2000 commodities boom. This boom can be dated at about 2004-2008, followed by an afterglow period of 2010-2014 with a big dip in the middle. Going back into the dip is no problem at all. It is logical and overdue.

That is one piece of evidence, but another and more urgent lesson for Commodity Boomers is this. Reporting 10 December, Bank of America analysts said that 56% of global GDP is currently supported by zero interest rates, and so are 83% of "soaring" equities on global bourses. Half of all government bonds traded in the world yield less than 1% a year. The most-basic and dangerous reason for this is that the post-2008 "recovery" of the global economy is an illusion, totally dependent on "free money". An increasing number of analysts and economic commentators say that when or if the free money is stripped away, we will have to face a a 1930s-style depression.

In a real economy of really slow growth, why should oil prices be "normally more than $100 a brrel"? Maybe Andy Hall thought he had the answer, but he has now thrown in the towel.

Energy Sector Junk Bonds
Forbes, 11 November, said that high-yield bonds issued by energy companies have inevitably come under pressure for higher interest rates as the oil price slides. Forbes cited the MacKay Shields High Yield Corporate team which believes that in many cases, increasing interest rates on energy sector "junk bonds" is simply a more accurate pricing of the fundamentals.

High-yield spreads = the interest rate paid by high risk borrowers versus central bank base rates near zero - have generally widened since mid-2014, but the energy sector now has the added driver of plunging oil prices. Since July, WTI crude has fallen by roughly 42%, from highs above $110 a barrel to around $63 as of December 10. In November, Forbes was commenting the impact on energy sector junk bonds, driven by a 25% fall in WTI prices.
One chart (from Forbes, below) is worth a thousand words, and shows the rapdily-rising impact of investor fear regarding now increasingly very high risk oil and energy assets



Running for Cover on Asset Cover
A trader operating in high-yield loans, quoted by Forbes, 11 November, said that "margin of safety' factors with increasingly risky oil-related assets was already weighing on loan pricing in the sector.  “When oil was trading above $100 a barrel, we felt that global fundamentals supported something closer to $80,” says Dohyun Cha, energy specialist at a High Yield corporate loan team. Cha noted that a bond issuer’s asset value estimate for a loan must exceed its net debt load estimate by at least 50%. Chu's team, as of early November was applyimg a $65-a-barrel criterion, but the barrel-price price criterion for loan financing is now a lot lower, reflected by recent proud claims by some US shale oil producers that "we can live with oil at $42 a barrel" – if our junk bonds still fly.

Chu and many other analysts say the basic problem has been complacency. “We felt that the market was being too complacent in assuming that oil could stay at $90 to $100 indefinitely,” he said. Ask Andy Hall why the so-called "smart money" also thought that.
An increasing number of corporate bond analysts and traders say the energy sector is being "fracked by debt", split into relatively safe, and much riskier asset domains in which loan costs will reflect the risk – and will soar. Exploration and production (E&P) will for example be less hard hit than the shale oil, deep offshore oil and frontier oil asset domains, where loan rates are already experiencing a rapid rise.  Equity market valuations for the energy sector will surely and certainly also reflect this winnowing of asset values, with a likely negative outlook for the equity share prices of the leading international oil majors, as well as energy corporations highly exposed to high cost oil regions and technologies. Maors like Shell, BP and Exxon wil be announcing new write-downs and further restructuring.

30-year Stampede Into High Cost Oil
For reasons extending into geopolitical and national security concerns, oil at any price became a poster child for corporate loan issuers applying criteria they would never use in any other sector, including energy. For the inveterate gamblers called bankers-brokers-traders this was the green light for an epic boom only lightly related to anything we can call energy-economic fundamentals. Like a poker player on an endless hot streak, avid speculators like Andy Hall and Phibro made billions for the companies they traded for, by placing one aggressive bet after another. To be sure, one of Hall's claims to Teflon status was that he anticipated the downslide in oil prices from mid-2008, following their "Goldman Sachs goosing". His problem was that he refused to see the post-2010 oil price boom as a debt-fueled sucker's rally.

The dimensions of the "new energy subprime" could be epic. As recently as year 2013, riding on overpried oil, Citigroup estimated that global spending in the oil and gas sector, heavily dependent on low interest loans, was well above $600 billion. How much of this becomes "red ink" is now the multi-billion-dollar question.

Knowing that "leverage is all", the cult idea that $100 oil was forever spurred a pyramid of junk bond issuance for the energy sector since 2010, which now has to unwind. According to Oil & Gas Journal, 1 February 2006, global capex (capital spending) in oil and gas was slightly less than $200 billion in year 2005. According to Barclay's Equity Research, 9 December 2013 global capex in oil gas through 2014, on 2013 trends would reach $723 billion and would grow further through 2014. This of course depended on two main constraints: the barrel price stays north of $100, and loan financing stays cheap, with a low mark-up from near-zero central bank rates, on energy sector junk bonds.

This hasn't happened and in fact is yet another classic case of the cancer of crony capitalism. Asset values had to grow "indefinitely". Interest rates had to stay super-low "indefinitely". The coming unwind of the energy sector subprime crisis will inevitably be panic-driven, tearing down the good with the bad among world energy assets. The LNG sector, for example, is a prime case for panic write-down treatment of its junk bonds, following similar debt-heavy financial collapses in the solar PV and windfarm subsectors of the energy finance pyramid. The impact on oil prices, as if we couldn't guess, will be to push prices down, further and faster, triggering another long bust cycle before the next boom. Yet another home goal for the crony capitalists!

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2014 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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