“Negative ripple effects”

The rally in crude oil has been red hot. In the three weeks since February 11, WTI shot up a short-crushing 34% to $34.69 a barrel at the moment. Now the talk in the oil patch is at what price these desperate shale oil drillers will once again increase production.

Continental Resources CEO John Hart and Whiting Petroleum CEO Jim Volker told analysts this week that they’d step on the accelerator once oil reaches the $40 to $45 range. After all, drillers have to produce oil to be able to service their mountain of debts. They can’t just switch to selling T-shirts.

Alas, that looming increase in production won’t help deal with the glut. And a glut it is.

Dallas Fed President Robert Kaplan hammered this home as part of a wide-ranging speech today. And he wasn’t speaking only for himself or stating his own wayward opinion. Instead, he started out his comments concerning oil with this: “It is our view at the Dallas Fed that….” So this is official.

The Dallas Fed, whose district in addition to Texas includes northern Louisiana and southern New Mexico, figured that global oil production in 2016 will exceed consumption by an average of 1 million barrels per day. So that would amount to adding another 300 million barrels by year-end to the already ballooning crude oil inventories around the world.

In OECD countries, inventories continue to rise, he said, and are now at “roughly 400 million barrels above the historical five-year average.”

But the excess of production over consumption is coming down to 500,000 barrels per day by the end of the year, not because production will decline, but because consumption in 2016 is expected to grow by about 1.2 million barrels per day:

These excess inventory levels will increase through 2016, and there is now some discussion in the industry about potential limits in storage capacity.

We estimate that the market will not find some degree of daily production/consumption balance until mid-2017 and, at that point, excess inventories will begin to decline.

Several factors and assumptions, based on data over the past several months, underlie this outlook, he said:

• The official return of Iran to the world oil markets
• Increased supply from OPEC nations
• Slower-than-expected supply declines from US producers despite substantial cuts in drilling and capital spending
• And slower-than-expected demand from emerging-market countries.

But he added that the outlook would be “meaningfully impacted by a change in OPEC production strategy” – in one direction or the other.

In this scenario, the glut would continue to get worse until mid-2017 and then it would, well, continue but it would gradually deflate as the by then breath-taking crude-oil inventories would be inching off their peak levels toward something resembling normal.

And this assumes that that $45-dollar WTI won’t kick off another shale-oil production boom in the US, in which case all bets are off. Kaplan:

Given these various factors, the ultimate timing of market production/consumption balance remains uncertain. In the meantime, we expect to see continued low prices and high levels of price volatility, as well as more bankruptcies, mergers and restructurings in the energy industry.

In early January, he’d called this phenomenon, the “‘even lower for even longer’ price outlook.” At the time, WTI traded above $30 a barrel. A month later, it dropped to $26 a barrel. Now it’s at $34.

But this nightmare in the energy sector isn’t contained to the oil patch. It has reached the financial instruments that could impact financial stability.

Oil-and-gas related bonds make up “a material portion” of junk bonds outstanding, he said. So the spreads between the yield of junk-rated corporate bonds and Treasuries have widened, and at the lower end of the scale, they have totally blown out. The average spread between Treasuries and corporate bonds rated CCC or lower is now over 19%. And companies with these kinds of funding costs are feeling the noose tightening around their necks.

Bond ETFs and mutual funds are loaded up with these bonds. Funds that have liquidity obligations that allow investors to pull their money out on a daily basis can come under heavy pressure when they face a wave of redemptions by spooked investors. This happened in December when Third Avenue’s Focused Credit Fund imploded, the first bond fund to implode since the Financial Crisis.

Corporate bonds are by nature illiquid, particularly when the market swoons. So funds sell what they can sell: the most liquid, high-quality paper first. Initially, there aren’t a lot of losses, and folks who get their money out first remain unscathed. But those who wait until the fund collapses get brutalized. This first-mover’s advantage is precisely what triggers runs on bond funds.

Thus, when mayhem in energy bonds causes investors to head for the door, funds are forced to sell bonds “more broadly in order to meet liquidity needs,” Kaplan said. Then the entire corporate bond market, the lifeblood of over-leveraged Corporate America, gets in trouble. And so he mused:

This is a good example of the potential negative ripple effects that can come from persistent weakness in the energy sector.

The bond market has enough problems already. Read…  Corporate Default Rate Jumps Past Lehman Moment

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