Satyajit Das: The slump in oil prices is fuelling financial instability globally

Das Capital: Revenues have reduced sharply, making it difficult to service debt

Satyajit Das
Tuesday 31 March 2015 09:26
Large movements in oil prices have the potential to create significant financial instability, especially in debt markets
Large movements in oil prices have the potential to create significant financial instability, especially in debt markets

Financial markets have generally assumed lower oil prices are good for asset prices, resulting from the positive effect on growth and lower inflation which extends the period of low interest rates. In reality, the large movement in oil prices has the potential to create significant financial instability, especially in debt markets.

Heavily indebted energy companies and sovereign or near-sovereign borrowers with large oil exposures face increased risk of financial distress. The boom in borrowings by energy businesses, especially shale gas and oil producers, has created a dangerous debt overhang. Energy companies now make up around 15 per cent of the Barclays US Corporate High-Yield Bond Index, up more than 300 per cent from 2005. Since 2010, energy producers have raised $550bn (£371bn) of funds. In 2014, more than 40 per cent of new non-investment grade syndicated loans were to the oil and gas sector.

During the boom, non-investment grade bond issues and loans for the oil industry were underpinned by high oil prices and the search for yield. Now low oil prices have reduced revenues sharply, making it difficult to service debt.

The industry’s weak financial structure and business model compounds the problem. A significant proportion of the industry is highly levered with borrowings that are greater than three times gross operating profits. Many firms were cash flow negative even when prices were high, usually debt-funded to maintain production. If the firms have difficulty meeting existing commitments, then the decrease in available funding and higher costs will create a toxic negative spiral.

Sovereign and near-sovereign borrowers in oil-dependent countries are similarly vulnerable. Energy companies, such as Brazil’s Petrobras, Mexico’s Pemex and Russia’s Gazprom are among the largest issuers of emerging market debt. Since 2009, they borrowed about $140bn in bond markets. Petrobras has around $170bn in debt, one of the most indebted companies in the world.

Many oil-dependent economies also face additional problems from a growing currency mismatch. Many producers borrow in dollars. Falling oil revenues as a result of lower prices reduce the dollar cash flow available to service the debt. Weak oil prices also drive weakness in the value of the domestic currency of oil producers, while higher dollar interest rates compound the mismatch.

For oil-producing nations, the financial problems of large, state-run producers have broader implications. Lower earnings, reduction in investment, lack of availability of finance and currency devaluation will lead to a weaker economy. In turn, this drives defaults and a further reduction in access to international funding. The problems have increasingly spread from oil-dependent economies to all emerging markets – a complicating factor is the fall in the supply of petrodollars resulting from the fall in oil prices, which has been important to these markets.

Since the first oil shock, petrodollar recycling has been an essential component of global capital flows. Historically, surplus revenues from oil exports accruing to producers accumulate as currency reserves which are mainly invested in government or high-quality securities. More recently, petrodollars have been invested in other assets, including equities, trophy real estate, sporting teams and high-end art. This has increased global liquidity flows, helping finance budget and trade deficits, and boosting asset prices as well as keeping interest rates low.

A prolonged period of low prices will reduce petrodollar liquidity and may necessitate realisation of foreign assets held by oil producers. This has potentially important implications for the value of the dollar, asset prices and interest rates globally. It will also add to pressures on increasingly fragile emerging markets.

Emerging markets have about 75 per cent of their $2.6trn debt denominated in dollars. A similar proportion of their $3.1trn bank borrowings is dollar-denominated. The large amount of dollar borrowing reflects low interest rates and size of the dollar market. But now the tightening of dollar availability is compounding the effects of a stronger dollar, weak local currencies and higher US rates.

The oil shock, if it persists, will have profound consequences for the global economy and geopolitical order. Its benefits are mixed, uncertain and unevenly distributed. Its effects on debt markets and emerging economies have the potential to trigger a profound adjustment in the asset price bubbles created by the innovative monetary policies in the aftermath of the great recession.

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