Analysts and government officials continue to raise concerns about low oil prices stoking the next global economic crisis, drawing comparisons with the 2008 mortgage meltdown. But why? At the core of this argument is the impact of low oil prices on the banking and investment sectors.
Mortgage lending to those with questionable credit coupled with housing price drops led to the 2008 economic meltdown as subprime mortgage holders defaulted in droves. The resulting defaults caused banks around the world to freeze credit, creating a cascading impact on business activity as companies were unable to access credit to support payroll and make operational investments. Ultimately government entities had to step in to stabilize the banks and restore economic stability.
So why are oil exploration and production (E&P) firms similar to subprime mortgage holders? When oil prices were high, banks offered these companies easy credit and lots of cash. This looked attractive to many oil and gas E&P firms that needed upfront capital to lease equipment and hire workers. For banks, the investment risk seemed manageable, as loans would support oil drilling and sales of oil would pay back the loans. That is until the price of oil tanked, forcing many oil and gas E&P and support services companies into bankruptcy. In fact, many companies overexposed to the cheap debt exuberance that percolated when energy prices were high may now be more likely to face bankruptcy as low oil prices can’t support debt service.
So, will these defaults result in broader economic strife?
There are reasons to be concerned. Banks are preparing for energy sector losses triggered by loan defaults by marking down loan values, setting aside reserves to handle defaults and reducing credit lines. To make matters worse, many of the hedging contracts oil and gas companies use to diversify against oil price volatility risk are expiring. Bryan Rich mentions two potential indicators of upcoming market strife, noting the fastest deteriorating companies are 1) European banks (trading at levels below the 2009 financial crisis) and 2) North American insurance companies (with heavy exposure to investments in high-yield debt of the oil and gas industry).
But, there are reasons to remain optimistic, since there are real differences between the oil crisis and the subprime meltdown. Compared to the subprime mortgage crisis, banks may have far less exposure to oil and gas sector loans (compared to levels of residential mortgages) and may have bigger capital cushions that allow losses to be absorbed. In addition, there is the potential for quick (-ish) fix to the oil crisis (namely the price of oil increasing), whereas it took one of the largest ever government interventions into private markets to fix the subprime meltdown.
How realistic is the quick fix? Prices could rebound if demand rises quickly, but who will drive the new demand? More plausibly, prices could rebound if OPEC decides to curtail production, allowing markets to reach equilibrium. On February 16, Saudi Arabia and Russia (and others) agreed to freeze (i.e. not increase) oil production if other producers follow suit. However, it seems the deal to cap production at record high levels (not cut production) is unlikely to materialize as Iran, a major OPEC member is eager to regain market share lost under sanctions.
With a quick fix seemingly out of reach, the potential for broader economic doom looms. The question is, how bad could it be?
