How Shale Oil Will Trigger the Next Recession

April 18 2016

The enormous decline in oil prices have made many headlines over the past year. The Dutch central bank (DNB) argues that lower oil prices are a ‘tax cut’ for businesses and good for economic growth. But is this true? In this article, I will look at the entire shale oil industry and show why the Dutch central bank's assumptions are wrong. When the next recession hits, we will be talking about subprime oil-loans, instead of subprime mortgages. The American shale oil crisis will take the world economy over the cliff into an abyss. Oil is the new subprime.

Loose Monetary Policy Not Only Stimulates Demand…

When economic growth stalled, central bankers were at a loss. According to Keynesian thought, in which central bankers have been trained, a drop in aggregate demand occurred. The only thing they need to do, is to stimulate that demand.

How do they go about doing this?

By lowering interest rates, it becomes less appealing to hoard money. If the opportunity cost to hold cash increases, people will tend to spend it instead of hoard it. Aggregate demand recovers. At least, so the story goes.

But central banks were wrong.

Monetary stimulus not only stimulates demand, and prices, but indirectly also supply. The higher oil prices are, the more profitable oil production becomes.

The American oil industry had almost $1 trillion dollar on its books in 2006. But the debt has risen to over $3 trillion dollar, a staggering threefold increase in less than 10 years. After oil prices surged (because of the loose monetary stance of the Fed), entrepreneurs borrowed on a massive scale to invest in shale oil projects.

The mix of low interest rates on the one hand, and high oil prices on the other, has led to a lethal cocktail.

The result of today’s central bank policy? Instead of stimulating aggregate demand, central banks only induced the next bubble. Just like central banks are to be blamed for the subprime bubble of 2008 and the dotcom bubble of 2001, central banks will be responsible for the shale oil bubble of 2016.

The Shale Oil Bubble

A few years ago, everyone believed that oil prices would remain high forever. Oil prices below $100/barrel were a thing of the past. A similar thing happened in the bubble years on the outset of the Great Depression. The famous American economist Irving Fisher uttered: “Stock prices have reached what looks like a permanently high plateau.”

“Permanently high plateau,” just like oil prices.

Opinions like these reveal that we are in the midst of a financial bubble.

I Warned Investors

Precisely a year ago, I summed up three things that investor should avoid to make money. One of those things, was to invest in “high yield” bond funds.

Common investors usually have no clue as to what the underlying assets of these high yield funds are. They have no clue about what they are investing in. Regulators have, probably without any intention, popularized the idea that bonds are per definition safer (less risky) than stocks.

These funds invest in “junk bonds,” risky bonds that were used to finance shale oil production in the US. And as oil prices kept increasing, just like housing prices, it was profitable to finance shale oil production with high yield junk bonds. As long as oil prices remain high, at least.

By now yields on corporate debt in the shale oil sector have surged. Today, those same bonds can only be sold for $0.50 on the dollar. Some companies are unable to roll over their debt, because interest rates in the shale oil sector now exceed 20 or even 30 percent annually. Many shale oil companies with maturing debt cannot get refinancing without going bankrupt.

Effect on Bank Balance Sheets

Many banks are heading for trouble when and if the (shale) oil sector collapses. Some banks have significant exposure to the shale oil boom in the US. A significant number of big banks might see 40 to 50 percent of their (Tier I) capital vanish if things go south.

In sum, a new banking crisis is probable if oil prices remain low for a longer period of time (below $50 or $40 dollar). That is why a low oil price is not an “unexpected, but welcome economic stimulus,” but rather a danger to the economy and a potential trigger for a new banking crisis.

And this time around, governments will not be able to bailout banks. They already took on staggering amounts of debt in 2008 to rescue the banking industry.

For now, a lot of bank credit in shale oil is still “investment grade.” But as we have seen in 2007 with subprime mortgage credit, an investment grade rating can quickly turn into junk status. It is only a matter of time before debt-financed shale oil companies have to roll over their debt against much higher interest rates.

Sentiment Is Starting to Shift

In the first quarter of this year, twenty-one shale oil companies filed for bankruptcy, representing a total of $31 billion dollar in junk bonds. For April, we already stand at $14 billion dollar in (shale oil) junk bond defaults. And according to credit rating agency Fitch, this is not the end. This quarter, bankruptcies in the oil industry will not slow down, but gain momentum. The worst is yet to come.

To shed some light on the potential impact of the shale oil problem: the total size of outstanding subprime mortgage debt was over $1 trillion dollar in 2007. The size of subprime oil credit is over $3 trillion dollar today.

If shale oil is indeed the new subprime, and indeed triggers a recession, then investors may find relief in the classical safe havens: the dollar and gold. Even though the latter might have some downside risk in the short run, especially after a rate hike (which I expect) by the Federal Reserve.

In the aftermath of a rate hike, the dollar might increase sharply and gold prices might decline. If this scenario would unfold, buying gold might be very interesting for an astute (euro) investor.

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