So oil stops going down and we rally, most likely because of a short covering rally before Janet Yellen speaks tomorrow. Who wants to be sure, if she says she's taking multiple rate hikes off the table, if someone's smart enough in Congress to ask about the domestic and international repercussions a collapse in oil might cause?
I have been adamant about the good things that can happen when energy prices go down. However, there is an underbelly that must be addressed, namely: The longer oil keeps breaking down, the more stress there really is in the system, and the worse the fundamentals get for the financial system.
Initially, when oil sold off, we saw a host of little and, frankly, inconsequential companies go belly-up.
That's no longer the case.
Now it's all about companies that used to be much bigger than they are now, companies like Chesapeake Energy (CHK), which is the blast zone of the decline of this market.
For those of you who aren't familiar with Chesapeake, this was once among the largest natural gas producers in the world. Founded by Aubrey McClendon, it borrowed big and bought assets in the key shales, making some monumental acquisitions with debt that, among other reasons, were instrumental in removing him from the CEO job.
McClendon had the foresight to recognize that natural gas was not going to grow much and he moved aggressively into oil while it was rising. When he left in 2013, the company had a market capitalization of $18 billion. Now it stands at $1.2 billion. More important, it owes a ton of debt racked up in McClendon's gigantic acquisition spree, as much as $16 billion, and that's become a real problem because this company had its cash flow stretched at much higher levels. Now that its natural gas is hovering at multiyear lows and oil is back well under $30, the cash-flow situation becomes critical, especially as $500 million in debt comes due next month.
We know Chesapeake has hired advisors to figure out what the company can do about debt maturity. Maybe sell assets? Maybe restructure somehow. But the chief thing you need to know is that this $1.875 stock has become incredibly significant in this market. First, we know Chesapeake, a very big company when you include all of the debt, owes a lot of people and a lot of companies and perhaps a lot of banks some real cash. Second, if Chesapeake is having problems here, then many companies that shared an intense lack of financial discipline will also be in trouble unless they have huge reserves of low-priced oil they can tap into.
Third, the market's not ready for these defaults even as they are beginning to be priced in. Much of the debt has been ensconced in high-yield debt funds, and if you haven't heard me before I am telling you that these must be sold. I mean must. This is no place to be reaching for yield as many of the companies in the index I follow, the iShares iBoxx High-Yield Corporate Bond ETF (HYG), are all getting hammered.
How far-ranging can the pain be? As far as major shareholders, one of the biggest is Carl Icahn, who bought a ton of Chesapeake stock -- he was there during the McClendon days. He has a big-enough balance sheet that I doubt he will suffer from his 10.98% holding, the second-largest shareholder. Interesting that Icahn is also the largest shareholder in Freeport McMoRan (FCX), with an 8.8% stake, another oil company with way too much debt that must make sales to stay one step ahead of the debt posse. And Icahn owns a 13.83% stake in Cheniere Energy (LNG), a company that has made deals to sell American liquefied natural gas abroad that may run into trouble if some of its customers run out of capital or try to breach the contracts, as the natural gas coming from Cheniere will now be well above world prices. I would take the other side of the trade on every single one of those positions. (Thank you, Carleton English, for compiling that data.)
Then there's the exposure to the banks. Ever since the major banks revealed they had, in many cases, several percent of their loans to oil companies and oil service entities, the banks have been obliterated. Worse, banks worldwide lent to commodity and oil companies and Chesapeake is a reminder of how far-flung this bad debt phenomenon might actually be.
You would think the oils have been the worst place to be in this market, but you would be wrong. It is the banks and the perception that oil is going to be the next big short, so to speak -- the next places where the loan losses will soar -- is causing incredible havoc. Just take a look at Bank of America (BAC), a stock that my charitable trust owns because it is the cheapest discount to a scrubbed book value than it has ever been. Sure, some of that is because the bank is the one that does best when the Fed raises rates. But therefore, the flipside is true, too, so if the Fed puts rate hikes on hold because of deflationary turmoil, Bank of America has the most to lose, especially because it is restricted in how many shares it can buy back and how big a dividend it can pay.
Still, the big discount to book didn't occur until we heard about how the company had made $17 billion in energy loans. That's $17 billion too many as it is hard to think who is big enough and needs a loan from Bank of America that isn't short on cash. Hard to believe that BAC's share price has repealed multiple years of gains and is back to where it was in 2013, but believe me there is a sense that, holy cow, here we go again with a bad loan spike and if you fool me once on housing, it's the banks' fault, but fool me twice, it's my fault.
How about these foreign banks? We see the declines in the stocks of Credit Suisse (CS) and Deutsche Bank (DB) and a whole lot of other banks that trade only in Europe and we have to presume that not only do they not have enough regular business, they, too, must be swimming in bad oil loans. Without any transparency, we can't be sure and we presume the worst in this market. The action in the European bank stocks, by the way, is perhaps the most frightening aspect of this market because we don't have a handle on their capital situation. They never were subject to the stringent stress tests our government put our banks through, so, unlike our banks, we don't know if they have the capital to deal with billions in soured oil and commodity loans that we know are out there.
Finally, there's the master limited partnership holdings out there, some of which have huge exposure to Chesapeake and could get really hurt if the company goes bust. You might have seen Williams (WMB) and Energy Transfer Equity (ETE) get slaughtered yesterday. Williams, which ETE is buying, has huge exposure to Chesapeake's related pipeline company and both stocks are down more than 60% on CHK default fears. Wealthy individuals are loaded to the gills with these master limited partnerships and they tend to trade together, so the losses have been staggering.
I don't mean to pick on Chesapeake. It's a little atypical: Most companies weren't as reckless when they cobbled together their portfolios. But many are still spending a huge mount on capital expenditures, much of which they don't have the cash on hand to pay for.
But many of you have asked how it can matter so much if oil stays down. The answer is that we will have more and more Chesapeakes over time. The silver lining? If we get enough Chesapeakes to stop drilling, oil will indeed find a bottom. In the interim, though, expect the pain that ripples through the system every time oil falls a dollar from here.