Follow-On Risks to Oil’s Latest Minsky Moment

At the end of last year, we argued that the Minsky moment had come to oil.  That after years of high prices and ideas that oil prices could only go up, there was extensive leveraging in the energy sector that broadly conceived, would have to unwind.  We anticipated that this was bigger than just the $90 bln of high yield debt issued by shale producers in the past three years.

At the end of last year, we argued that the Minsky moment had come to oil.  That after years of high prices and ideas that oil prices could only go up, there was extensive leveraging in the energy sector that broadly conceived, would have to unwind.  We anticipated that this was bigger than just the $90 bln of high yield debt issued by shale producers in the past three years.

There was an ecosystem of sorts, both upstream and downstream, predicated (and leveraged) on high priced oil.  There were chemicals and supplies needed for fracking.  There were railroad cars needed for shipping.  There were direct and indirect jobs in the shale area that are at risk.  There is also impact on those housing markets for example.  Also predicated on high carbon prices were investment and employment in the renewable energy space.

Specific to the shale sector, we expressed concern that banks were repeating the lending habits to the housing market, basing credit extensions on the (anticipated) value of the collateral than the business itself.   In October and April, lenders typically re-calculate the value of the properties (tied to oil reserves) offered as collateral.  It is common to use the average price of oil over the past 12 months for the calculation.  The 12-month average for the continuation contract of light sweet crude, which is a handy though not completely accurate proxy for shale, stood at $78.20 at the end of last month, down from $98.50 at the end of September 2014.

In the coming days, banks expect to cut the credit lines of many shale producers.  In anticipation of this, some firms have tried to raise alternative financing by selling equity and/or arranging longer-term loans.  There have also been a number of failures and a few take-overs.

The price oil traded higher after putting a low in late January near $43.60 on continuation basis.  The high came a few days later near $54.25.  It traded broadly sideways through the first week in March before breaking down against and hitting $42.00 on March 18.  It reached a high last week of almost $52.50.  It retraced about 50% of that bounce and found support near $47.25. 

Looking at a weekly chart, technical indicators such as the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD) did not confirm the mid-March lows.  This is what technicians call a bullish divergence.  It would suggest a near-term risk to the upside.  This fits in nicely with the recent news stream that includes the first weekly decline in US oil production since January and the Energy Information Administration (EIA) of the Department of Defense, which anticipates that three of the seven shale areas are likely to see a decline in output this month.  Technically, there is potential toward $54-$56 a barrel.

However, the ultimate low in price may still lie ahead.  There are a couple of wild cards.  A nuclear deal with Iran would see a sharp increase in their oil exports as sanctions lift.  There are other supply concerns.  Surveys suggest an OPEC output increase.  Not that oil is a homogenous market, but the 36k barrel a day decline in US output last week appears to have been more than offset by others, including by OPEC, which according to surveys stepped up their output to new highs.  While US refineries appear to be coming out of their seasonal turnarounds early, refineries in the Middle East and Asia are just entering their maintenance period.

Another downside risk for spot crude is the excess output that is filling up storage capacity.  There is a debate about how much unfilled storage capacity remains, but the fact that the cost of storage has risen suggests a real or anticipated shortage.   US crude inventories are at their highest level since records were kept beginning in August 1982.  Another sign of storage capacity issues is that the CME just launched a futures contract for storage (not in Cushing where futures delivery takes place, but at the LOOP (Louisiana Offshore Oil Port).  On March 31, at the first auction, investors bought futures contracts for about 11 mln barrels of oil (a little more than a week’s worth of US production).

Mr. Crude Meets Mr. Minsky Round Two is republished with permission from Marc to Market