Okay, okay, okay… I admit it… I am just now getting around to reading through old Economist editions. Sue me. Or don’t… I can’t afford the legal expenses. I have small children at home and they want to be fed, like, almost every day! (That’s “humor” there.)
So, I’ve made it all the way to July. There I stumbled across this piece that should really scare anyone worried about the economy in West Texas or, for that matter, in the rest of the country.
You may wonder why this is. Well, as the article notes “(not) all bubbles, it would appear, are equally bad… the crucial variable that separates relatively harmless frenzies from disastrous ones is debt” (internally citing two scholarly reports, which may be found elsewhere on the website).
As another article in the Market Oracle noted, and which I warned about in another blog a couple of years ago here, the problem we have in the West Texas economic environment is that shale producers are addicted to debt vehicles (like market derivatives), which are substantially similar to those which brought down the housing market. And, as a brief exercise in recent history may remind us, the problem with using debt (especially derivatives based debt) to finance continued operations is that when the market coughs, everyone else catches cold.
You see, an oil-based economy is not, by itself, a contagion for the rest of the market. In fact, it is often counter-cyclical. As the price of oil goes up, the rest of the economy begins to stagnate. This is because there is a baseline energy demand (at least for now), and the price of oil is, therefore, an expense that cannot be remedied. (Although there are other sources of energy, most people and companies cannot readily switch from petrochemicals to, say, solar power. Thus, there is a relative like of market substitutes.) As oil prices go up, demand for other things (like big, gas-guzzling cars) goes down… The converse is also true, which is why you see various articles, like this one, talking about the economic stimulus provided by low oil prices.
The problem in the current environment is that, as oil prices fell, oil companies turned first to the equities markets in an effort to survive until low oil prices reversed themselves. When the markets were not able to provide sufficient liquidity to maintain operations, they turned to issuances of new debt… Banks, in turn, are still relatively gun-shy about risk, so they packaged up these issues and sold them off. The people who buy these types of issues are distressed debt investors and… investors seeking yield.
Let us undertake another simple exercise… Who, do we think, would be a likely investor seeking high yield in order to – let’s just say – negate the continuing bad effects of poor investment choices coupled with years of underfunding? Could that possibly be… I don’t know… institutional investors like, for instance, pension funds? Hmm… California, alone, has already lost $5 billion on investments in the energy industry. Luckily, there are no other funds that need to make up dramatic shortfalls… Or are there?
Anyway, this takes me back to, as always, the economy in West Texas. It looks like actual economists (unlike me, who only plays one on this site) are starting to come around to this notion that maybe things are not all hunky-dory in the Oil Patch. For example, here is Karr Ingham noting that the initial estimates maybe missed the mark with how far the local economy has already fallen (if this sounds familiar, it’s because I already argued that fact here and here).
Some have argued that regional exploration companies are a good investment for bond investors because its asset sheet shows a high breakup value, which would likely cover investors in the case that the company had to sell off its assets – which would, ostensibly, make bond investors whole. This argument contains many assumptions that should be unpacked before the unwary investor dumps funds into any oilfield company, however (lest you think I am alone in arguing that money may be too easy to come by in the oilfield, read an excellent analysis from an actual professional here).
The first is that, at the secured debt listed on the asset sheet is the only secured debt outstanding against the interests of the company. As any real estate lawyer in West Texas can tell you, however, this is likely not the case! Any operation that assists an oilfield company (read, every single oilfield services organization in the world) has, according to Texas law, the right to claim a mechanic’s and/or mineral lien against the properties upon which it works for certain statutory periods after the operation is completed. Additionally, some liens attach not just to the realty itself (the underlying mineral interests that is) but also to all equipment, materials, personal properties, etc. owned by the company and used on that leasehold during the performance period of the underlying contract. Because these liens are nascent until a third party acts on them, they are not added to the bottom line until they are filed.
That means that there are possibly, and quite literally, significant amounts outstanding for any distressed company that may affect any distribution to underlying bondholders. For owners of derivative instruments that are associated with debt from oilfield companies, this is a blind risk of exposure.
To top all of this off, the argument that now may be a good time to invest in distressed oilfield debt also assumes that the cost of the underlying assets are, themselves, also relatively static. This too, however, is likely not the case. First of all, one of the largest assets held by any exploration company is going to be the value of the proven mineral reserves that it has under lease. Most of these are valued making market based projections. Many of these are based on outdated models that assume something on the order of $60 oil (this morning, the price per barrel was something like $45).
Third, it assumes a perfect market, in which there are willing sellers and willing buyers of assets for fair market value. If the recent sales of blocks off the coast of Mexico have taught us anything, however, it is that assuming that someone wants to buy oilfield assets (including minerals) is a dangerous assumption.
Finally, and most worrying to my selfish mind, this argument assumes that the company will be broken up! By arguing that the breakup value of the company is high enough to make bondholders whole, this analysis assumes that the company’s ongoing oilfield operations will not be enough to sustain it over the long-term, necessitating a sale which will, supposedly, take care of the debt holders. The equity holders, however, and the employees, are toast.
If that happens that means more layoffs in the Oil Patch, specifically around here (since many companies possess large assets in the Permian Basin). If, as I argue above, the assets have to be sold at a bargain, then that means that debt holders also take a haircut… Enough trims like that, and everyone starts to bleed.