Oil market spiral threatens to prick global debt bubble, warns BIS

By Ambrose Evans-Pritchard: 6:33PM GMT 05 Feb 2016

The global oil industry is caught in a self-feeding downward spiral as falling prices cause producers to boost output even further in a scramble to service $3 trillion of dollar debt, the world’s top watchdog has warned.

The Bank for International Settlements fears that a perverse dynamic is at work where energy companies in Brazil, Russia, China and parts of the US shale belt are increasing production in defiance of normal market logic, leading to a bad “feedback-loop” that is sucking the whole sector into a destructive vortex.

“Lower prices have not removed excess capacity from the market, but instead may have exacerbated it. Production has been ramped up, rather than curtailed,” said Jaime Caruana, the general manager of the Swiss-based club for central bankers.

The findings raise serious questions about the strategy of Saudi Arabia and the core Opec states as they flood the global crude market to knock out rivals in a cut-throat battle for export share. The process of attrition may take far longer and do more damage than originally supposed.

Oil exporters are embracing austerity and slashing government spending, leading to a form of fiscal tightening that is slowing the global economy.

Speaking at the London School of Economics, Mr Caruana said the sheer scale of leverage in the oil and gas industry is amplifying the downturn since companies are attempting to eke out extra production to stay afloat. The risk spreads on high-yield energy bonds have jumped from 330 basis points to 1,600 over the past 18 months, amplifying the effects of the oil price crash itself.

The industry has issued $1.4 trillion of bonds and taken out a further $1.6 trillion in syndicated loans, driving up the combined energy debt threefold to $3 trillion in less than a decade.

While US shale frackers hog the limelight in the Anglo-Saxon press, many of these energy groups are giant “parastatals”, such as Rosneft, Petrobras or China National Offshore Oil Corporation (CNOOC).

The BIS said state-owned oil companies increased debt at annual rate of 13pc in Russia, 25pc in Brazil and 31pc in China between 2006 and 2014, much it in the form of dollar debt through offshore subsidiaries. These oil companies do not respond to pure market pressures since they are cash cows for government budgets.

The nexus of oil and gas debt is just one part of an over-stretched financial system, increasingly exposed to the dangers of a “maturing financial cycle” and to punishing moves in the global currency markets.

Mr Caruana said an “illusion of sustainability” has blinded borrowers and debtors, lulling them into a false of security when credit was easy and asset prices were rising. This illusion can die in the blink of an eye. “The turning of the financial cycle can be quite abrupt,” he said.

The BIS calculates that debt in US dollars outside the United States has surged to $9.8 trillion, a fivefold rise since 2000 and an unprecedented level for the global monetary system as a whole.

While some of this dollar debt is matched by dollar assets and dollar earnings, a big chunk has been used to play the local property markets of east Asia, Latin America or eastern Europe, and another chunk has been gobbled up by “non-tradable” sectors that have no natural currency hedge if it all goes wrong.

The BIS estimates that 23pc of every dollar raised in bonds by emerging market companies has been diverted into the “carry trade”, stoking internal credit bubbles.

The average level of private credit in these countries has jumped from 75pc to 125pc of GDP since 2009. Corporate leverage is now more extreme than in the US and Europe. Profit ratios have dropped from 16pc to 9pc in four years, a clear warning sign.

The carry trade was highly profitable in the heyday of zero interest rates and quantitative easing by the US Federal Reserve, when credit was temptingly cheap and the falling dollar generated a currency windfall.

What looked like a one-way bet has proved to be a Faustian Pact now that the Fed is turning off the spigot, especially in countries such as Brazil, South Africa, Turkey, Russia, Malaysia or Azerbaijan, which have seen their currencies plummet. The “broad” dollar index has soared by 32pc since July 2011, the steepest and most sustained rise since the Second World War.

Mr Caruana said there is now clear evidence that this liquidity is drying up. Dollar loans to emerging markets peaked at $3.3 trillion and began to fall in the third quarter of last year, as chastened debtors pared back their exposure. Chinese companies have slashed their dollar liabilities to $877bn from $1.1 trillion in late 2014.

We may be approaching the eye of the storm. “The feedback loop between deleveraging and emerging market currency depreciation presents challenges that should not be underestimated. The policy room for manoeuvre has been shrinking,” he said.

“The temptation may be to try to keep the financial booms going, or to give them a new lease of life, but this will be just a palliative unless the stock of debt is adjusted,” he said.

The BIS seems to be telling us that reckoning can still be orderly if we face up to reality, or end in a chaotic wave of defaults if we do not. Either way, the debt must clear.

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