2020 Oil Crash
Markets are going crazy, oil price dropped to $30 a barrel and so did Dow Jones by 7% on Monday morning slumping almost 2,000 points in the red after Coronavirus shock and the oil war.
In addition, trading halted because there was a circuit breaker in the New York Stock Exchange (NYSE).
We’re currently facing difficult times created by a series of events I will proceed to explain.
OPEC meets with Russia in order to agree on the oil price
It all started with last week’s oil price plummeting due to the coronavirus spreading outside of China, which is why OPEC and Russia came together to potentially reduce production to artificially increase the price.
Russia wasn’t willing to reduce production because 38% of the country’s GDP is a result of oil production and most likely they couldn't afford to lower the production.
OPEC didn’t agree with Russia’s decision, especially Saudi Arabia, which is why they did the opposite: Increase production and flood the market with oil in order to drop the price.
This drop was the second-biggest in history, after January of 1991, as shown in the chart.
Increasing production and flooding the market wasn’t a problem for Saudi Arabia because it can produce oil at a lower cost than Russia and the United States, but it most likely affects the U.S. economy deeply, especially the credit markets.
The price of oil is being sold for $30 when the cost of producing it in the United States, with the Shale producers, is $73 a barrel.
The price discrepancy between the cost of the barrel and what it costs them to produce it will create a problem in the credit market because Shale corporations could become insolvent.
But oil price dropping wasn’t the only thing that triggered today’s situation, it just added more danger to a bigger background that’s been developing for years.
Let’s start by pointing out the dangers.
Market crash precedents
It all dates back to 2008 when the Federal Reserve implemented the ZIRP (Zero Percent Interest Rate Policy), and both pension funds and other financial institutions were pushed out of the risk curve.
They were forced to invest in the corporate bond market in order to meet their liabilities.
To understand this better, it’s important to differentiate the types of bonds offered in the corporate bond market:
Investment-grade bonds and high yield bonds. I mention the categories because it’s crucial you comprehend the difference between these two.
Pension funds can only put their money into investment-grade debt.
The big banks and other financial institutions like J.P. Morgan go into the high yield bond market or junk market as I call it, to benefit from the higher yield.
Because they were forced to get into the corporate bond market, a lot of their money went into oil corporations, because 11% of the BBB debt market or the investment-grade debt is based on oil companies bonds.
The junk debt market is comprised mostly of shale corporations bonds.
This situation may seem like madness, but it’s caused mainly by the central banks.
Since the government bonds interest rates were so low, financial institutions couldn’t meet their liabilities by buying that type of debt.
So they were forced to look for riskier assets, such as corporate bonds and shares, rather than treasuries.
Alongside this, central banks inject money into the economy by buying assets from the private sector business like insurance companies, pensions funds, non-financial firms among others, in order to boost spending and keep inflation on track.
As the Bank of England Monetary Policy Committee establishes:
After the purchase of those assets, their price increases but the yield is reduced, this means the return on the assets falls, which encourages the asset sellers to use the money they receive from the bank to switch into other financial assets like the company’s shares and bonds.
As the purchase of these assets starts to increase, the prices rise and the yields go down.
That’s the main reason all of this money was forced into riskier assets like oil and Shale corporations.
Now, there’s another important character to mention here: Moody’s rating agency.
They’re responsible for rating the bonds in the market, from AAA, BBB down to junk.
This is important because if they downgrade most of the bonds currently in BBB status to junk, pension funds will have a problem because they can only invest in BBB bonds and up, anything between AAA and BBB.
But, that’s not all, there are other credit markets also being affected, like the USD Credit Market outside the United States, which means there are other countries who will be touched by the crisis.
Many countries and corporations loaded up on dollar-denominated debt in 2012 because de DXY had a huge drop, around 75. To give you some context the index was at 95 this week and it just dropped from a 100 about a month ago.
This, combined with ZIRP, made it very cheap debt to attain, it was a huge benefit for many countries and corporations at the time, but they took a big gamble.
Most of their revenue comes in the form of another currency, for example, Colombian Pesos, so if the exchange rate goes against them they’re going to have a hard time servicing their debt.
But, maybe some of them thought the exchange rate wasn’t going to be a big issue because they were oil producers, until today when oil has experienced a historical drop.
Those countries will now have a hard time paying their debt too.
Yet, this whole story doesn’t stop here, we’re going further to fully understand the current situation.
The big ‘market crash' picture
We’re going further into the corporate bond market where debt has grown very much since 2008, as shown in the image.
Today’s view of the market looks something like this (the interest rates provided are hypothetical):
Pension funds need to accomplish a 7% yield to meet their liabilities
They won't be able to do it with a 4% interest rate they have to leverage up and borrow money from other financial institutions like banks in order to fulfill their responsibilities, so things start to get very difficult for them.
But, in this scenario, we're not even considering BBB bonds will be downgraded into junk status because of the oil price drop.
The situation gets worst. We already know oil prices are dropping and Coronavirus fear and sickness are spreading, while at the same time the stock prices are going lower.
The stock market fell by 1,800 points this week, which applies greater pressure to the economy.
Why?
There’s another component: Most of the American companies are full of debt because in 2012 they were loaded up to buy their shares back.
Therefore, when Moody’s rating agency sees the asset value is dropping, it will reduce their rating to junk status, and even though oil corporations are only the 11% of the BBB debt market, there’s also a very probable scenario where most of the BBB bonds are downgraded into junk status.
If this happens, interest rates will go through the roof because the junk debt market will now have an additional 4 trillion dollars supply with the same pool of capital.
I will assume, by being very gentle, that interest rates will only double.
If that’s so, how will the companies drowning in debt be able to service theirs? I’m not only referring to oil corporations, but also to companies like AT&T and Ford, amongst others that bought their shares back in 2012.
Besides all of this, there’s also a probability of the country going into recession, when this happens, corporation’s revenue is lowered, meaning they have less cash coming in while debt payments grow into infinity.
I’m not even mentioning other companies already in junk status, like Tesla and Uber, between others.
They won’t be able either to go into the market and take their money at a double interest rate.
They’ll all go bankrupt, that’s the bottom line.
Returning to pension funds, if they’re able to survive the situation I described above, they’ll return to the market and find a bigger pool of cash for a limited supply of investment-grade debt, which has an opposite effect than the one we talked about.
Instead of increasing, the interest rates will dramatically lower, so if pension funds couldn’t get their yield with a 4% interest rate, there’s no way they will with a zero or 0,5% interest rate.
The government would have to reach the taxpayers to announce pension funds are bankrupt, which is why they will have to increase property taxes or do whatever they need to get your last dime.
If taxes are increased in a time of recession, the tax revenue will go off a cliff.
There's no way that pension funds will be able to survive
Regardless of this, baby boomers are all retiring, and who has been the main driver of the stock market other than the corporations over the past 25 years?
This generation has put all of their money into de 401k, meaning that if we go through a crash, there’s no way they’re going to buy the debt, they can’t afford to.
In conclusion, there will no buyers in the corporate bond market neither in the stock market.
All of this crisis feeds on itself, and it all started with oil prices crashing, the coronavirus pandemic, and the “everything bubble” the Fed has created.
All will come crashing, which is why I’m calling this chapter Doom Vortex Infinity.
Now, the whole picture makes room for a question:
Did Putin just throw a hissy fit or is he playing a three-dimensional chess game with the Unites States economy and the dollar?
Oil price endgame
It’s also relevant we don’t forget about the other credit market outside the U.S I mentioned before.
To make it easier I made up this example.
There’s country #1 and corporation #2 who were both loaded up in USD debt in 2012, and are still producing oil, but with the recent drop of price from $100 to $30 a barrel, the situation has changed for them, it puts them in a bad spot.
Country #1 now has two options:
1. Going into the FX market, printing their own money, buying the dollars they need to pay their debt at the cost of devaluating their currency and generating domestic inflation, crushing along the way corporation #2, because their revenue now comes in the form of the recently devaluated currency while having a dollar-denominated debt.
2. Pumping more barrels of oil off the ground to be able to service the debt. In order for them to do so, they’ll have to produce more barrels, which creates a greater supply of oil in the open market.
If there’s more supply, the oil price will go down, making the Doom Vortex infinitly much worse.