In last week's column "The Biggest Current Threat to the Economy," I discussed the potential for a rate increase by the Fed to have the unintended consequence of exacerbating the current economic slowdown and perhaps causing the economy to tip into recession rather than expand.
The logic is that an increase in short-end rates would logically cause an immediate increase in long-end Treasury yields and mortgage rates, which could cause demand for housing to decline next spring and cause the economy to approach recession even faster.
I've expanded on that issue in the columns since and will shift this column to the related biggest market threat that may result from an increase in the Fed funds target rate.
Put succinctly, the threat is that an increase in the Fed funds target rate puts upward pressure on the U.S. dollar, which puts downward pressure on oil prices. If spot, for delivery, West Texas Intermediate (WTI) oil prices break below $40 per barrel specifically because of this action, the price could quickly fall to the $30 range.
The extenuating circumstances that could exacerbate that move include 1) the potential for the consumer to respond poorly to a Fed rate hike, causing immediate demand for oil distillates to decline, 2) the continued production in excess of demand leading to storage capacity constraints in the U.S., 3) the continued production of oil in excess of demand by both OPEC and non-OPEC countries, most importantly Saudi Arabia and Russia, respectively, and 4) the continued deceleration of economic activity, and thus demand for oil, in China.
The impact of this on the financial viability of the companies in the alternative oil sector is excellently explained by Art Berman in The Petroleum Truth Report's recent commentary, "Only 1% of the Bakken Play Breaks Even at Current Oil Prices."
The public companies in that sector, tracked by Berman, are all losing money at current prices with bankruptcy assured for many if the price for oil does not rise, let alone falls further.
Listed in order of those with the greatest losses to the least are; Whiting Petroleum (WLL), Hess (HES), EOG Resources (EOG), Continental Resources (CLR), Statoil ASA (STO) and Marathon Oil (MRO). (Whiting Petroleum is part of TheStreet's Stocks Under $10 portfolio. EOG Resources is part of the Action Alerts PLUS portfolio.)
Of these, all but Statoil are independent and small in relation to the large integrated companies. As such, all are facing the risk of imminent bankruptcy, which will be necessitated by the defaulting on existing loans, which will be necessitated by the inability of their bankers to continue to extend existing term loans or rolling credit facilities to them.
The bankers will be precluded from extending the existing loans due principally to the fact that the reserves that were considered proven a year ago, and thus eligible to be used as collateral for the loans, are now unproven and uneconomic at current prices and can therefore not be used as collateral for loans, according to the rules and guidelines for such provided to the banks by the Office of the Comptroller of the Currency.
It is theoretically possible that a bank could extend the existing loans and even provide additional credit if the bank officers are of the opinion that the price of oil will increase within the term of the new loans, which typically run from three to seven years, and thus provide the borrower with a financially viable method of repayment.
However, with many loans coming due requiring extension decisions to be made by lenders while the Energy Information Administration has published expectations for oil prices to stagnate at least through 2016, it is improbable in my opinion that bank officers will accept the potential personal legal liability associated with extending loans that ultimately cannot be repaid.
I think it is more probable that the alternative oil sector is about to enter a period wherein the majority of the independent producers will default and enter bankruptcy, with their equity being wiped out, their bankers absorbing losses of 100% or close to it on the extended loans, and the large integrated oil companies purchasing the assets for close to nothing.
Next week, I'll write about the potential and probable banking system repercussions of having to absorb these losses.