When Shale Goes Subprime

  And so it begins.

“U.S. Steel Corp. said it will idle plants in Ohio and Texas and lay off 756 workers,” reports this morning’s Wall Street Journal, “becoming one of the first big U.S. industrial casualties of the recent collapse in global oil prices. Both factories make steel pipe and tube for energy exploration and drilling.”
Most of the jobs are being cut in Lorain, Ohio. “What appeared just a few short weeks ago as being a productive year, [with new hires in December and extra turns going on] has most abruptly turned sour,” said a letter from the president of the union local.
Overnight Brent crude prices slipped below $50 a barrel. They’ve recovered a bit since. Ditto for West Texas Intermediate, $48.38 as we write.
  “The oil collapse is going to cause far more pain than most people seem to realize,” ventures our Chris Mayer.
“If history is any guide, there will be no quick recovery. And the effects will go well beyond just oil stocks.
“The oil bust will sting banks that lent freely to the oil patch.” That’s what happened three decades ago. Oklahoma’s Penn Square Bank failed in 1982… which snowballed into the 1984 failure of Continental Illinois, the biggest U.S. bank bust up until the Panic of 2008. (Indeed, the modern bailout got its start with Continental Illinois, as The 5 chronicled last year.)
This time around, “the latest energy boom needed a lot of money to build out infrastructure and drill wells,” Chris explains. “Lenders happily funded these efforts. Such loans were often made assuming $80 oil. Many of these loans were riskier high-yield bonds, or junk bonds. A JPMorgan analyst estimated if oil stayed below $65 a barrel, then 40% of all energy junk bonds could wind up in default.
“Most oil companies have hedges in place for 2015, meaning they’ve locked in higher oil prices. But even conservative energy companies will see their hedges expire in 2016 and could run into trouble.”
Vulnerable banks identified by SNL Financial include Comerica… International Bancshares… and ViewPoint Financial. “This makes for a good list of stocks to avoid,” says Chris, “or at least be careful about.
  “It’s not just loans to energy firms that bite back,” Chris goes on.
Again the ’80s are instructive: “Oil patch banks got stuck with real estate debt that the oil boom supported,” he explains. “The same thing could happen again. Hotels, retailers and homebuilders with energy exposure could all suffer. KB Home, for instance, generates 30% of its sales from Texas.
“Houston is at the center of this energy ecosystem. You can clearly see the impact of oil prices in its real estate statistics. Much like the tree rings of an oak, they mark the lean and flush years. Net absorption, for example, tells you how many square feet the market leases each year. The chart below gives you a look at office space. You can see the last time the price of oil fell a bunch — in 2008. Absorption went negative. Meaning the amount of empty space went up.

“Property companies with big exposure to Houston include: EastGroup Properties, Cousins Properties and Parkway Properties,” says Chris. “It’s going to be a tough 2015 for them unless oil makes a quick reversal.”
Footnote: Nearly 20% of the workers U.S. Steel is letting go are based in Houston.
  It’s at this moment we pause to consider an uncomfortable thought: Perhaps the boom in America’s shale patch — a meaningful part of it, anyway — was a big hairball of malinvestment.
“Malinvestment”: Near as we can tell, this delicious English-language word was coined by the Austrian School economists of the 20th century — Mises, Hayek, Rothbard. Malinvestment is the flow of capital into places where no sane person would ordinarily put it — were it not for the stupidity of central bankers and their easy-money policies.
The Federal Reserve’s easy money delivered us the dot-com bubble in the late ’90s and the housing bubble of the mid-2000s. Malinvestment.
How much of the shale boom might have happened if the Federal Reserve hadn’t been keeping its thumb on interest rates the last six years? How much exploration and drilling took place simply because explorers and drillers could borrow cheaply?
Or to put it in more stark terms: Were $17-an-hour Wal-Mart greeters in North Dakota the embodiment of a newfound American prosperity… or a sign something was profoundly wrong?
We’re not prepared to say it’s an either-or proposition. No doubt good old American know-how played a role in the boom… and we won’t rule out connivance between Washington and the Saudi Arabian princes playing a role in the bust. But we’d be remiss to ignore the malinvestment question…
  “The combination of easy money from the Fed with high oil prices (arguably caused by the former) led to massive malinvestment in the shale industry that now must be unwound,” asserts our acquaintance Erik Townsend — a hedge fund manager who trades oil futures.
Erik says much of the problem lies in the kind of trades shale producers used to hedge their production — called “three-way collars.”
If you want to dive into the details of how these trades work, check out today’s Overtime briefing, below. In the meantime, here’s the bottom line: “We needed $60 crude to hold to avoid an outright crisis in high-yield credit issued by shale drillers, and it didn’t. Now we’re going to have an outright bloodbath… I expect $40 Brent before this is over, and the risk of credit contagion on the scale of subprime mortgages is very real.”
Erik then picks up a theme we touched on Monday: “Shale drillers are going to lay down a LOT of rigs and stop drilling. This will lead to supply destruction. Then the price of oil will go to the moon and it will be time to restart the shale revolution.”
  But the story doesn’t end there: “High-yield debt issues from shale drillers will have exactly the same connotation as ‘subprime-backed CDOs’ had in 2009,” Erik explains. “You won’t be able to sell the stuff for half what it’s worth just because of the stigma. Where’s the money going to come from to re-start the shale revolution?”
It won’t come from the banks; they’ll be too gun-shy to lend to the smaller players. So those smaller players will have to issue new shares if they want to raise money.
“That may occur in a significantly depressed equity environment compared with today,” says Erik. “The result — oil prices keep screaming higher, as the easy-money policies that enabled the last round of the shale ‘revolution’ aren’t there this time.”
What if the Federal Reserve resumes “quantitative easing” and steps on the monetary gas pedal? Erik won’t rule it out. “But investors who get nailed by the coming wave of high-yield defaults will still have the taste of blood in their mouths, and will still be reluctant to buy more debt issued by the shale patch.
“This all sets up for a MAJOR resurgence of inflation a couple years down the pike, led by an oil price spike.”
[Ed. note: Two weeks ago, Erik posted a comprehensive video assessment of the state of play in the oil market — including a long-term crude price outlook. It’s well worth your time. Check it out right here.]
  Major U.S. stock indexes have arrested their two-day drop today. At last check, the S&P 500 was up a half percent, to 2,013.
Stock traders seem unconcerned about the latest word of a slowdown in Europe — inflation in the eurozone clocked in overnight at negative 0.2% year over year. But the impact on the currency markets is what you’d expect — the euro down to $1.18 and the dollar index now above 92 for the first time since November 2003.
Treasuries are selling off, pushing yields higher; the 10-year is back up to 1.98%. Gold has shed a bit of its gain from yesterday, now $1,215.
  2015 will be the year of the buyout in the medical device sector, predicts Rick Pearson of Agora Financial’s Catalyst Trader.
“Big-cap medical device makers to acquire small targets in order to maintain their growth,” Rick explains. “This is almost certain to happen in 2015, and there’s an easy way to play the trend at making money off a stock.
“The big-cap medical device makers all had very strong years in 2014. The giant Medtronic (MDT) was up by more than 30% for the year. Boston Scientific (BSX) was up by about 10%. Cardiovascular device maker St. Jude (STJ) was up by around 13%.
“But in each case, we’ve now been seeing a trend of decelerating revenue growth along with pressure on gross and net margins. There’s a very clear need for these companies to buy their future growth by acquiring small competitors in the space.”
Rick’s readers are privy to the name and ticker of some buyout bait he sees with the potential to double or triple.
  O, the perils of central planning: There’s a McDonald’s french fry shortage in Venezuela.
Blame it on currency controls… which are putting a hurt on imports. No hard currency, no fries.
“McDonald’s restaurants are coping by replacing the spuds,” according to Reuters, “with salad or local fare such as fried yuca or ‘arepa’ corn pancakes — but Golden Arches fans are none too happy about the new meal.”
Or as one frustrated patron said, “Hamburgers don’t go with arepas.”
Officially, Venezuela runs a 61% inflation rate. The reality is three times as bad, according to the Troubled Currencies Project maintained by Johns Hopkins econ professor Steve Hanke — 179%, based on the black-market exchange rate with the dollar.
  “Not sure where your readers find conspiracy in Jim’s writing,” a reader writes in reply to a cranky email we published yesterday.
“This is just straight common-sense stuff. Look at the facts, so obvious. If the readers cannot understand this, then they should not subscribe here, that simple.”
  “With all due respect,” writes another, “Jim Rickards’ advice to prepare for both inflation and deflation is as useful as the answer to the question will markets be up or down in 2015: Yes.
“Heck, if you buy a put option and a call option, you are protected either way, except you stand to lose all your investment. No thank you.”
The 5: If you want to place all your bets on one side of the boat, have at it. But we don’t share your implicit confidence the Federal Reserve is capable of achieving its 2% inflation target on an ongoing basis… and the risk it could miscalculate either way is significant.
In 2010-11, we could have cast our lot with the crowd that said the Fed’s “quantitative easing” would lead to IMMINENT HYPERINFLATION (usually in bold, all-caps and a color font). But good judgment prevailed.
Jim, by the way, thinks gold can provide excellent protection from both inflation and deflation. Considering how every dollar invested in Homestake Mining in 1928 turned into $6.76 during the course of the Great Depression, he has a point…
Best regards,
Dave Gonigam
The 5 Min. Forecast
P.S. We’ll be sharing Jim’s 2015 outlook in tomorrow’s episode. In the meantime, you might want to check out this long-term thought experiment he shared recently.

As promised, here’s Erik Townsend’s explanation of how “three-way collars” work… and how Wall Street engineering managed to land some shale oil drillers in deep trouble. Erik, take it away…
“Regular” collars work by buying out-of-the-money put options on crude oil struck below the market. These puts form the hedge that protects drillers from a price drop between time of drilling and time of production. Those “protective puts” are paid for by selling in-the-money puts struck above the market. The net result: The driller’s profits are limited to the top of the collar range, but he’s guaranteed the ability to sell his oil at the bottom of the collar range.
Now enter the financial genius of some unnamed 29-yr old Maserati-driving kid on Wall Street. Boy genius offers to spruce up the performance of a traditional collar by also selling a third leg of puts struck WAY below the market.
So, for example, if crude was trading for $100 at the time the hedge was purchased, the collar range might be $90 to $107, meaning the driller is guaranteed a minimum price of $90 and a maximum of $107. But then boy genius shows up with the idea of selling a whole bunch more puts struck at $70. That’s “free money because the price could never go that low”, and improves the driller’s collar range to $92 to $109. Because the price could never go below $70.
If that sounds as if it rhymes with “Housing prices could never go down across the board because they never have before”, that’s because it’s exactly the same mentality.
Well guess what? Oil prices are below $70, and the drillers who unwittingly bought these three-way collars to hedge their production are no longer hedged. All the downside from here is pure risk for them, and some may not even understand what was sold to them by their hedging “consultant”!

Dave Gonigam

Dave Gonigam

Dave Gonigam has been managing editor of The 5 Min. Forecast since September 2010. Before joining the research and writing team at Agora Financial in 2007, he worked for 20 years as an Emmy award-winning television news producer.

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