Oil Company Defaults: the First Dominos Set to Fall

The first eight oil companies, standing on the edge of default, are about to run out of time as key deadlines approach. While eight small oil companies few people have ever heard of doesn’t really sound like an economic cataclysm in the making, it could be the start of a $19 billion dollar wave of junk bond defaults. By some estimates, that wave could swell to over $40 billion and that’s just this year.

They have names like Energy XXI Ltd., SandRidge Energy Inc. Peabody Energy, Linn Energy and Goodrich Petroleum Corp. Not exactly household names, but together they could start a surge of defaults that could lock up credit markets and, while it may not be 2008 all over again, it will certainly rhyme with those dark days on many levels.

Low Oil Prices Unsustainable for U.S.

When oil was $100 a barrel and gas prices hovered between four and five dollars a gallon, the U.S. and Canada embarked upon a wave of new oil and gas exploration that included new drilling techniques and extraction from tar sands and shale deposits. All of these extraction techniques are expensive in relative terms, but profitable as long as oil prices stayed in the forty- to fifty dollar a barrel range. But oil didn’t hold and, when stockpiles started to increase and oil prices started to fall, our allies-in-name-only, the Saudis, started pumping more oil there, which drove prices down to levels that were unsustainable for U.S. and Canadian producers.

How it Rolls Downhill

To finance all that new oil extraction, oil producers went to what’s called the junk bond market. The term “junk” is appropriate because the investments they fund are both speculative and risky. In exchange for the increased risk, junk bonds pay a higher return. The downside is if those investments go bad, that money gets wiped out. With no insurance or government backing for junk bonds, investors can lose their entire investment. Right now the junk bonds that financed that new wave of oil extraction projects are set to wipe billions in investor money off the books.

This Won’t End Well

Since junk bonds are risky, the market prices in a certain default rate. That background default rate for junk bonds is usually around two percent. If even a small number of the energy companies on the bubble now default on their bonds, we could see that rate go north of five and six percent, more than three times the norm. How we got in trouble in 2008 was that highly speculative bonds were being sold on the open market, and it wasn’t just private investors buying them, it was also banks and investment houses. Remember when banks were supposed to be careful with depositors’ money? Not anymore. Today the securities market is a Wild West gambling hall, and big banks are the suckers at the table.

When banks and investment houses lose money in junk bonds gone bad, the banks have to pay that money back. When banks are short of cash, they stop lending. Small business owners can’t borrow money to expand; medium and large companies can’t borrow money to make payroll and other expenses. It also means that many small oil companies, which may have been borrowing to make ends meet, are going to be cut off. The economic ripples go even farther because banks also stop buying junk bonds which means new projects don’t have the money to get off the ground.

The oil market also might not be the end of the bad news. Oil wasn’t the only commodity facing depressed prices, there was also copper, aluminum and every other mineral that we claw out of the ground. So, it’s not just oil companies on the bubble, they’re joined by mining companies and metal refiners. The total in defaults is conservatively over seventy billion and could approach $100 billion by the end of the year. Now we’re talking some real money, the kind where bank execs come to Congress for another bailout, with more empty promises that they’re never going to do it again…until the next time.