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 broadly conceived, that would have to be 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, that was predicated (and leveraged) to high priced oil. There were chemicals and supplies needed for fracking. There were the 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. Investment and employment in the renewable energy space was also predicated on high carbon prices.
Specific to the shale sector, we expressed concern that banks were repeating the lending habits to the housing market, where credit was extended based on the (anticipated) value of the collateral than the business itself. In October and April lends typically re-calculate the value of the properties (tied to oil reserves) that have been 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 are expected to be cutting 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 was put in a few days later near $54.25. It traded broadly side ways 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, the lows in prices seen in mid-March were not confirmed by technical indicators such as the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD). 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 3 of the 7 shale areas are likely to see a decline in output this month. Technically there is potential toward $54-$56 a barrel.
However, the ultimately low in prices 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 are lifted. There are other supply concerns too. Surveys suggest that 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 the futures are delivered, but at the LOOP, the Louisiana Offshore Oil Port). On March 31, when the first auction was held, futures contracts for about 11 mln barrels of oil (a little more than a week's worth of US production) were bought.