Oil Bust Contagion Hits Wall Street, Banks Sit on Losses

Oil swooned again on Wednesday, with the benchmark West Texas Intermediate closing at $60.94. And on Thursday, WTI dropped below $60, currently trading at $59.18. It’s down 43% since June.

Yesterday, OPEC forecast that demand for its oil would further decline to 28.9 million barrels a day next year, after having decided over Thanksgiving to stick to its 30 million barrel a day production ceiling, rather than cutting it. It thus forecast that there would be on OPEC’s side alone 1.1 million barrels a day in excess supply.

Hours later, the US Energy Information Administration reported that oil inventories in the US had risen by 1.5 million barrels in the latest week, while analysts had expected a decline of about 3 million barrels.

So the bloodletting continues: the Energy Select Sector ETF (XLE) is down 26% since June; S&P International Energy Sector ETF (IPW) is down 34% since July; and the Oil & Gas Equipment & Services ETF (XES) is down 46% since July.

Goodrich Petroleum, in its desperation, announced it is exploring strategic options for its Eagle Ford Shale assets in the first half next year. It would also slash capital expenditures to less than $200 million for 2015, from $375 million for 2014. Liquidity for Goodrich is drying up. Its stock is down 88% since June.

They all got hit. And in the junk-bond market, investors are grappling with the real meaning of “junk.”

Sabine Oil & Gas’ $350 million in junk bonds still traded above par in September before going into an epic collapse starting on November 25 that culminated on Wednesday, when they lost nearly a third of their remaining value to land at 49 cents on the dollar.

In early May, when the price of oil could still only rise, Sabine agreed to acquire troubled Forest Oil Corporation, now a penny stock. The deal is expected to close in December. But just before Thanksgiving, when no one in the US was supposed to pay attention, Sabine’s bonds began to collapse as it seeped out that Wells Fargo and Barclays could lose a big chunk of money on a $850-million “bridge loan” they’d issued to Sabine to help fund the merger.

A bridge loan to nowhere: investors interested in buying it have evaporated. The banks are either stuck with this thing, or they’ll have to take a huge loss selling it. Bankers have told the Financial Times that the loan might sell for 60 cents on the dollar. But that was back in November before the bottom fell out entirely.

As so many times in these deals, there is a private equity angle to the story: PE firm First Reserve owns nearly all of Sabine and leveraged it up to the hilt.

The same week, a $220-million bridge loan, put together by UBS and Goldman Sachs for PE firm Apollo Group’s acquisition of oilfield-services provider Express Energy, was supposed to be sold. But investors balked. As of December 2, the loan was still being marketed, “according to two people with knowledge of the deal,” Bloomberg reported. If it can be sold at all, it appears UBS and Goldman will end up with a loss.

And so energy-related leveraged loans are tanking. These ugly sisters of junk bonds are issued by junk-rated corporations, and they have everyone worried [Treasury Warns Congress (and Investors): This Financial Creature Could Sink the System]. Their yields have shot up from 5.1% in August to 7.4% in the latest week, and to nearly 8% for those of offshore drillers [“Yes, it Was a Brutal Week for the Oil & Gas Loan Sector”].

Six years of the Fed’s easy money policies purposefully forced even conservative investors to either lose money to inflation or venture way out on the risk curve. So they ventured out, many of them without knowing it because it happened out of view inside their bond funds. And they funded the fracking boom and the offshore drilling boom, and the entire oil revolution in America, no questions asked.

Energy junk bonds now account for a phenomenal 15.7% of the $1.3 trillion junk-bond market. Alas, last week, JPMorgan warned that up to 40% of them could default over the next few years if oil stays below $65 a barrel. Bond expert Marty Fridson, CIO at LLF Advisors, figured that of the 180 “distressed” bonds in the BofA Merrill Lynch high-yield index, 52 were issued by energy companies. And Bloomberg reported that the yield spread between energy junk bonds and Treasuries has more than doubled since September to 942 basis points (9.42 percentage points).

The toxicity of energy junk bonds is spreading to the broader junk-bond market. The iShares iBoxx High Yield Corporate Bond ETF fell 1.2% to $88.43 on Thursday, the lowest since June 2012. And at the riskiest end of the junk-bond market, it’s getting ugly: the effective yield index for bonds rated CCC or lower jumped from 7.9% in late June to 11.4% on Wednesday.

After not finding any visible yield in the classic spots, thanks to the Fed’s policies, institutional investors – the folks that run your mutual fund or pension fund – took big risks just to get a tiny bit of extra yield. And to grab a yield of 5% in June, they bought energy junk debt so risky that it now has lost a painfully large part of its value, and some of it might default.

Oil and gas are inseparable from Wall Street. Over the years, as companies took advantage of the Fed’s policies and issued this enormous amount of risky debt at a super-low cost, and as they raised money by spinning off subsidiaries into over-priced IPOs that flew off the shelf in one of the most inflated markets in history, and as they spun off other assets into white-hot MLPs, and as banks put now iffy bridge loans together, and as mergers and acquisitions were funded, at each step along the way, Wall Street extracted its fees.

Now the boom is turning into a bust, and the contagion is spreading from the oil patch to Wall Street. Energy companies are cutting back. BP, Chevron, Goodrich…. They’re not cutting back production by turning a valve. They’ll keep the oil and gas flowing to generate cash to stay alive, and it will contribute to the glut.

Instead, they’re cutting back on exploration and drilling projects. It will hit local economies in the oil patch and ripple beyond them. As energy companies slash their capex and their stock buybacks, they’ll borrow less, those that can still borrow at all, and there won’t be many energy IPOs, and there may not be a lot of spinoffs into MLPs or any of the other financial maneuvers that Wall Street got so fat on during the fracking and offshore drilling boom. The fees will dry up. And some of the losses will come home to roost on bank balance sheets.

The contagion is already visible on Wall Street. Susquehanna Financial Group downgraded Goldman Sachs to neutral on Wednesday, citing the mayhem in the oil markets and the impact it has on junk bonds and leveraged loans and the other financial mechanism by which Goldman’s investment and lending divisions sucked fees out of the oil patch and its investors. And this is just the beginning.

But the contagion of junk debt isn’t limited to the oil patch and its backers. It’s already spreading beyond it. Read… Retailer’s Subprime Explodes, Shares Crash 40%, Junk Bonds Fall into “Price Discovery”

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  6 comments for “Oil Bust Contagion Hits Wall Street, Banks Sit on Losses

  1. Uncle_Frank
    Dec 11, 2014 at 8:09 pm

    Being in the middle of the West Texas oil boom area it’s amazing to watch the sudden change. All those unfinished new motels, apartments and homes. Is this a repeat of the 1980s oil bust?

    • Dec 11, 2014 at 10:05 pm

      Uncle Frank, when did you start noticing this phenomenon? Did this start with the oil price crash this summer/fall, or did it start before?

  2. VegasBob
    Dec 12, 2014 at 2:38 am

    Those who know me are well aware that I think the entire alleged ‘economic recovery’ of the past 5-1/2 years has been nothing but a statistical mirage – a gigantic fraud that someday will come to be seen as the greatest hoax of the 21st century. And I have never wavered from that viewpoint.

    I have never believed for a single moment that any good would ever come from the Fed’s rampant money-printing, no matter how much lipstick the Fed applied to make it look pretty. The various QE money-printing schemes reminded me of sticking heroin-filled IV tubes into the veins of a brain-dead patient on ICU life support, and praying that somehow the patient would come back to life. Sadly, I think the patient is more like Joan Rivers, who never recovered.

    I have also viewed all of the various government stimulus programs as basically one-shot deals, not even remotely capable of sustaining additional economic growth in the long run.

    Now, as I watch the 2014 oil price collapse I am reminded of 2008. It makes me wonder if the Greater Depression is now resuming in earnest…

  3. john tucker
    Dec 12, 2014 at 10:38 am

    Is this a repeat of 2008?, with the financial collapse of the US real estate bubble?

    there are similarities, but no, its not.

    Is this a repeat of 1986, when Saudi Arabia flooded the world with cheap oil and it led to the stock crash here in 1987?

    no, its not.

    This time we don’t just have financial firms collapsing …. Merrill Lynch, Bear Sterns, Lehman Brothers, AIG, they were all “too big to fail” but they were small enough to bail out…

    So tell me, is the Federal Reserve, and Congress, going to bail out Venezuela, Mexico, Nigeria, the Ukraine, Russia, Japan, and Canada?

    Anybody who buys this dip will find themselves sleeping under a black plastic garbage bag tent a little quicker than they would have otherwise, but pretty much, we are all doomed here.

    Its been good to know ya ….

  4. dgjesquire
    Dec 14, 2014 at 10:38 am

    I work in the oil patch south Bakken area (Dickinson, ND). US’s first greenfield
    oil refinery project in nearly 40 years broke ground in autumn, 2013. This diesel
    refinery will daily process nearly 850,000 gallons diesel and kerosene (jet fuel) and minor byproducts to be shipped to other mid-stream players.

    It has employed variously 450-625 staff all trades, union and not. Mostly not.
    This has been financed as DAS and others note, being a partnership between MDU (Dakota utility) and others.

    A second MDU (identical) plant is scheduled for ground-breaking next month. I wonder about that at this moment actually. I was laid off (RIF’d) on Friday, 12/12/14 as the turmoil continues unfolding. It was a good year as long as it lasted.

    • Dec 14, 2014 at 11:25 am

      dgjesquire, sorry to hear you got laid off. Are you seeing a lot of layoffs in the Bakken? Or are they limited at this point, from what you can see, to the project you were working for?

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