Oil and gas companies borrowed heavily when oil prices were soaring above $70 a barrel. But in the past 24 months, they've seen their values and cash flows erode ferociously as oil prices plunge — and that's made it hard for some to pay back that debt.
This could lead to a massive credit crunch like the one we saw in 2008. With our economy just getting back on its feet from the global 2008 financial crisis, timing could not be worse, especially in an election year. It makes you wonder: How could this happen again? Quite easily, as it turns out.
Realted: Why Oil Prices Will Rebound in 2016
Industry fundamentals are being misunderstood.
A $30 Nymex West Texas Intermediate crude price on a screen is the price paid when that barrel is delivered to Cushing, Okla. However, the producer of that same barrel in the Permian Basin will receive only $27 per barrel. Lesser quality crudes such as West Texas Sour might only fetch $15 a barrel. When prices were above $100 or even $60, those margins mattered less. With oil around $30, it's a much bigger deal.
A similar problem exists with lender's reserve values used for credit judgments. Notwithstanding the persistent decline in oil prices, commercial banks still use escalated price decks. These often mirror or exceed slightly, the forward price curve on the Nymex. Today, a $30 WTI barrel is forecast by the futures market to be sold at $39 per barrel a year from now. Those escalations become very significant, again, because of the margin squeeze.
With global oil demand flat, or even declining somewhat, OPEC price "hawks" producing all they can, OPEC price "doves," Saudi Arabia and its near neighbors producing to regain market share, and inventories at record highs — is a price escalation likely? The banks believe it is.
No matter how you cut that cake, there will be a flood of hard defaults with bank lenders and bondholders over the coming few months.
Significant year-end losses and write-offs are also coming, and very likely more write-offs in the ensuing quarters. Auditors will likely start to qualify their assessment of whether firms are a viable "going concern." Those also constitute an event of hard default with most lenders. These specific events of hard defaults with a senior lender generally will create a cross-default on other debt styled securities.
Related: How Low Can Prices Go? 10 Key Changes in the Oil Market
Even more importantly, most oil-price hedges, price swaps/derivatives, also have cross-default provisions. Thus, counterparty credit risk begins to escalate as those parties are forced to disgorge cash payments on those instruments.
Given the ferocity and rapidity surrounding this meltdown, can lenders effectively process this burgeoning inventory of defaulted credit? Time will tell, and there is a relative paucity of experienced workout/restructuring professionals to be spread around. Let's now add to that the banks to which the loan originators syndicated these credits. Highly doubtful they possess the army of specialists required to work through this problem.
Here are a few more gauges of the crisis to come: Since 2006, an additional $1 trillion of capital expenditures by just 59 companies has been spent on shale drilling and operations, according to oil-and-gas industry site OilPro.com. And another $1 trillion of energy-bond debt has gone on the books, according to the Bank for International Settlements. Energy-company bonds will sell off and create a pall of risk avoidance across all industries.
A staggering $2 trillion of debt was meant to generate a 3-to-1 increase in value. That value today is definitively less than half of what was spent. Overinflated year-end 2015 reserve values and hard-defaulted credit facilities will combine with an absence of private and public equity markets. The contagion through the expanding and loosely regulated derivative market is surely destined for surprises. Leases will be forfeited and meaningful plugging and abandonment liabilities will build. If the company cannot pay, the banks will be forced to do so.
Now, let's take a look at the 2008 credit contraction. There were overinflated values, aggressive and lax lending, deteriorating credit worthiness, an expanding and unregulated derivatives market, and a gross underestimation of lender exposure, coupled with expectations that price increases would cover credit errors.
Related: How the Saudi-Iran Crisis Could Drive Oil Prices Lower
Oh, and home prices dropped 61 percent over three years during that crisis, according to the Case-Shiller Index. Oil prices have declined 69 percent in just two years.
But, there's a very important difference: Houses had a value, albeit only for the dirt in the worst-case scenarios. Uneconomic oil and gas reserves – those that have been deemed to be not economically viable to extract – have zero value and then create further liabilities to plug them up.
Near term, we are going to see devastatingly bad news in energy company 10ks and conference calls. And then comes the recognition that it's even worse than that.
The selloff in energy bonds now underway creates general risk avoidance across the board. Ballooning loan write-offs hit the major banks and those smaller banks to whom the loans were syndicated. The manifestation of counterparty credit defaults and its cross defaults hit the banks again and many other firms that began originating swaps.
Even with the selloff to date, one cannot gauge the magnitude of the problem and how it might play out. But we know one thing for sure: It will be ugly.
This article originally appeared on CNBC. Read more from CNBC:
Oil prices could spike 50% higher in 2016: Analyst
Hit TV show 'Friends' is no longer on a break
Putin takes on disarming tone with West as oil prices plunge