Something about learning nothing from history

It’s incredibly cliché, but the truth of it can’t be argued: what we learn from history is that we don’t learn from history… or something to that effect. In yet another follow-up to what has unintentionally turned into an ongoing series (here, here, and here) about the decline in oil prices, I’ve started to notice that things are feeling very reminiscent of the lead up to the mortgage crisis.

Prior to the mortgage crisis, we had a real estate industry high on years of asset appreciation and believing that nearly any investment in real estate, no matter how crass, would automatically be a winner because real estate prices could do nothing but rise for the foreseeable future. This widespread mentality lead to banks giving mortgages to people who had no business borrowing the amounts of money they were receiving. The banks didn’t care, because real estate prices could only go up, so their risk exposure was zero – or so went the belief. Then one day, as everyone and their mother was flooding the market with flipped houses they were sure to make a fortune on, the unthinkable happened: real estate prices began to decline. One would think that the impending meltdown of the industry would only affect the industry itself – not so in the Wall Street Casino States of America. Greedy Wall St. folks behind the scenes wanted to cash in on this “can’t lose” real estate boom too. So they made these extremely marginal mortgages into complex financial instruments and they sold insurance against defaults on these mortgages, with all these decisions being made under the assumption that real estate prices would continue rising for near eternity so no holder of these investments would ever take loses even if people did default on their mortgages. So when that fantasy scenario didn’t play out, it didn’t only crush the physical owners of real estate, but the entire first-world’s financial system.

The current situation with oil is looking frighteningly similar (albeit on a smaller scale). Once again we have a market that people almost unanimously believed to be headed skyward for eternity. Much in the same way people jumped into houses they couldn’t actually afford assuming rapid value appreciation of the house, drilling companies have spent the last 2-3 years diving head-first into extremely marginal projects involving very low oil reserves and exceedingly high drilling costs – all under the assumption that high-priced oil was here to stay and would only continue higher. Then it didn’t.

No worries though. There’s no systemic risk this time. The oil price crash will clean up the market, the poorly planned projects will take their drills and go home, prices will stabilize somewhere higher again, and we’ll be back to business as usual. Wrong. Just as with the mortgage crisis, this would be a terribly naive assumption. Whenever there is easy money to be had and a bubble is inflating, count on Wall St. to be there making reckless investments.

Rice Energy Inc. (RICE), a natural gas producer with risky credit, raised $900 million in three days this month, $150 million more than it originally sought.

Not bad for the Canonsburg, Pennsylvania-based company’s first bond issue after going public in January. Especially since it has lost money three years in a row, has drilled fewer than 50 wells — most named after superheroes and monster trucks — and said it will spend $4.09 for every $1 it earns in 2014.

That’s right, almost a billion dollars invested into a company that has a proven track record of hemorraging money for the past three years. What kind of insanity is that? The same type we saw pre-2007 collapse. There are very large amounts of money in the bond market backing these extremely marginal drill projects. Just as in real estate, these poor investments looked tolerable when oil prices were sky-high and on the rise. Now, with a >50% decline in WIT crude per barrel price, suddenly we’re on the verge of a meltdown. Energy companies make up over 15% of the entire US junk bond market:

cotd-high-yield-energy

Just like the mortgage derivatives and credit swaps, these bonds are spread throughout the financial system as assets of bond funds, retirement accounts, and the like. They’re owned by people who don’t even know they own them. So what’s the risk? How many of the main US drill areas remain profitable at the current (as of this writing) $55/barrel WIT price? Turns out… almost none of them.

cotd-shale-breakevens

So let’s recap what we have here: A market in which wild and reckless investments were made under the assumption that the underlying commodity price would always rise, massive outstanding liabilities to bond holders, and a plunge in the underlying commodity price that just put the bond default risk on these already flighty investments through the roof.

Yup, things are looking just like they did minutes before the mortgage meltdown. Who will be on the hook for all the Wall St. trading losses this time? You will – thanks to that nice Cromnibus bill that passed with the Citigroup written Dodd-Frank repeal.

 

 

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