The Coming Energy Subprime Rout

By Andrew McKillop
1-31-14

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The Financial Subprime Model and Crisis

The 2008 global financial crisis can be traced back to early 2006 when the US subprime mortgage market began to display rising mortgage defaults. By late 2006 this had impacted and pushed down US housing and real estate prices after a near-decade of fast growth, at rates far above general inflation as measured by consumer price rises (CPI). Americans watched as their primary source of wealth became devalued. By 2007, prime or regular mortgage markets were also showing rising default rates. Massive quantities of financial assets pinned on the growth of both types of mortgages featured CMOs or collateralized mortgage obligations, a variant of CDOs or collateralized debt obligations. These were joined by CDSs or Credit Default Swaps as the main transfer mechanisms of the lost value and confidence ­ and loss of collateral ­ in the financialized real estate sector, to the general financial, banking and insurance sectors, and then to the overall economic system and all related markets.

By mid-2008 this was a worldwide banking, finance and economic crisis, despite its origins only concerning about 7.5 million US housebuyers who had received subprime loans but had no realistic ability to ever pay back their loans. The global slump from mid-2008 caused a wave of banking crises and massive falls in nominal paper values for assets of all kinds ­ including oil and energy. In 2007-2008 oil futures traded on major markets like New York's Nymex reached an all-time peak of about $147 per barrel. At the bottom of the asset slump in 2009 they had fallen to about $39 per barrel.

From the 2009 nadir, financial assets and especially stocks and shares, and oil, were expanded or “rebounded” in nominal paper value so fast and so much, on the back of massive central bank QE and government bailouts, that the world's stock and energy asset markets are now sitting on another time bomb of artificial value and misplaced confidence, waiting to implode. For energy sector assets including everything from oil and gas drilling land concessions, oil and gas pipelines and other transport assets such as power grids, LNG terminals and tankers, oilfield equipment and supplies, electricity metering equipment, windfarm towers and mill components, and solar cell manufacturing assets the recovery since 2009 was at least as extreme and unrelated to real economic fundamentals as the general financial asset recovery.

The post-crisis bull market for energy sector assets has its own special features, to be sure, but current extremely overvalued energy assets have the basic underlying need for extreme-high final market and consumer energy prices, or the prospect of growing prices. The US mortgage subprime boom had the basic need of constantly rising, and high real estate prices. The only question today is whether the pile of general financial assets, or those in the energy sector, will tumble first. Another question is also set. If we get a global energy subprime crisis, can this trigger a worldwide economic slump?

The Market Has to Recover

The energy sector's financialized assets are now under attack due to lack of confidence and uncertainty in the “asset value growth paradigm” and can implode as in the sequel to any other debt-based asset expansion boom. Until 2006-2007, and even in early 2008 a pretence could be made that subprime CMOs, CDOs and CDSs were not waiting to implode. They were said not to be worthless and “the realty sector had to recover”. The final dependence of real estate value on the rest of the economy was either ignored or sidelined as small and non-critical.

In exactly the same way as housing and real estate, energy prices and energy asset values have a fundamental driver in the health of the general economy and for energy the global demand for energy of all kinds. If this demand is growing slowly, or is not growing at all, runaway growth in derived energy financial assets will at some time hit a brick wall.

The notion of “compartmentalized” firewalls and bulkheads inside the economy was often used during the prelude to the 2006-2007 US subprime crisis to claim there was no crisis, and everything was fine. This completely ignores the role of financialization and debt-related “financial instruments” spanning the entire finance-banking-insurance sector. The same Financial Herd faith-based argument about “firewalls and bulkheads” is used to claim that energy sector assets are not overpriced, not heavily distorted or badly priced, and global energy prices “can only grow”. One classic example is the notion that while US shale gas is moving rapidly towards a crisis stage, and US natural gas prices are extremely low, high or very high gas prices outside the US, high oil prices everywhere, and extreme-high electricity prices in Europe will somehow act as firewalls and stem any general sector-wide financial crisis in the energy sector. Arguments are made that high energy prices can themselves spur or accelerate general economic growth, when one fundamental analytic base of stock market cycles and asset boom-slump sequences concerns the cost of essentials like food and energy, and the amount of “discretionary spending” able to power asset growth in other sectors of the economy.

High and constantly growing energy prices are the key collateral for the energy subprime, like growing house prices were for the mortgage subprime crisis. When energy prices decline or slump, this will sooner or later impact energy asset prices. Market rigging as an attempt to prevent this happening is a highly logical result.

In the week ending 24 January, US natural gas prices made a “surprise recovery” but with probably low staying power, growing by 20% in one week. Henry Hub prices reached about $5.15 per million BTU, equivalent to oil at $30.04 a barrel. Reeling back the story to 2010, the last time US gas was priced at $30.04 per barrel of oil equivalent, the “shale gas revolution” had gone critical and was running riot.

Today, the sequels are coming fast. The US “shale gas revolution” was based on a no-holds-barred drilling frenzy, with a linked land grab as drilling concession prices soared like something from a Thorsten Veblen tale of late-19th century capitalistic madness. Drilling concessions were changing hands at several thousand dollars per acre for multi-square-mile patches! The fracking boom was in overdrive. US natural gas output grew at double-digit annual rates and with no surprise at all US gas prices quickly suffered a historic collapse, falling to a historic low of $1.92 per million BTU in 2012. In Asia and Europe, conversely, gas prices in 2012 were as high as $17 per million BTU.

The Volatility Paradigm

Between the low-high extremes for global gas in 2012 of about $2 and $17 for a million BTU, we could argue the “rational price” has to exist, and is neither of the extremes. For market traders of course, price volatility is an article of faith and source of profit, as well as trading thrills, but for market operators and especially political deciders, market volatility is feared due to rising volatility usually meaning that overpriced financial assets will slump.

Telltale signs of “asset value correction” are now widespread in the energy “patch”. For example the well-publicised financial woes and investor concerns of Royal Dutch Shell and the financial meltdown in US shale gas. Extreme high energy asset prices, and extreme high energy prices ­ except when they are absurdly low like US shale gas ­ are other telltale signs. Corporate borrowing by Big Energy to finance an asset buying spree is another sign, all of it predicated on extreme high energy prices holding forever. If they do not, for example the current threat of so-called feed-in tariffs for electricity in Europe being reduced or even terminated (as in Spain), governments will almost certainly have to deal with “troubled assets” in the energy sector, and provide financial support.

How the US subprime happened is a simple question, with not-simple answers. Apart from the belief or hope that real estate prices “could only grow” the 2008 subprime rout concerned the inevitable sequels to an explosion of corporate and private debt ­ finally responded to by more debt, of the public kind.

Before the subprime crash, any kind of asset relating to US realty was a go-go betting chip. After the crash, the chips were worth nothing. This is the sequence which now threatens Big Energy, which in the period since 2000 responded to “challenges” like peak oil and climate change, OPEC unwillingness to hand out drilling concessions, dependence on Russian oil and gas, and other real or imaginary problems - by financializing itself. Asset price volatility is now inherent and intrinsic, made even more certain by energy sector financialization being a process where “can't lose” energy assets are fabricated and traded. At the end of the day, when a “major correction” of asset prices ensues, we can be certain that shareholders, taxpayers and consumers will be paying for the energy subprime rout, in the same way as they are still today paying for the post-2008 financial subprime rout, one way and another.

Energy Price-Value-Fear Prime

Not so very long ago, about 2005, the imminent threat of oil shortage and prices at triple digit dollar numbers per barrel was primetime. Crisis advocates from Jim “Clusterfuck Nation” Kunstler to Michael “The Prophet” Ruppert, not forgetting Richard “Olduvai Gorge” Duncan and the Pope of Peak oil, retired geologist Colin Campbell were regularly cited and quoted with forecasts of petro-doom. Today in 2014, German household electricity consumers pay about 25 euro cents per kilowatthour pricing their “increasingly green” electricity at about $535 per barrel equivalent of energy.

Possibly amazing to some, these electricity prices have in no way been high enough to save German former world-class solar photovoltaic manufacturers like Q-Cells from bankruptcy. The same applies to wind electricity and the recurring corporate debt crises of mill and equipment manufacturers, from Suzlon of India to Vestas of Denmark. Across Europe and in many other places from Singapore to Shanghai, gasoline at $7 or $8, or even $9 a US gallon, pricing oil “at the filling station pump” at up to $370 per barrel, is commonplace today. Yet oil majors like Shell, BP, Exxon, ENI and others are forced to declare “disappointing earnings”, high levels of project write-offs, continued extreme capital spending to assure sufficient energy supply in the future, and so on. This is new normal.

Sector-wide financialization in energy helps explain this seeming paradox. The fear of oil shortage which we do not have, and the fear of high energy prices ­ which we do have ­ are the classic and permanent rationales for the energy subprime.

Royal Dutch Shell in the week ending 31 January announced its fourth-quarter 2013 profits were 71% down, either despite or because the corporation had spent about $45 billion on oil and gas exploration and development in 2013, including heavy betting on Iraqi energy gaming chips, but total sales revenues for the year only came in at around $40 billion. Shell was a self-proclaimed corporate advocate of “Go for Gas”, for reasons the company on occasions said were linked with or included peak oil and geological depletion of lower-cost or conventional oil reserves. On other occasions it said gas was vital in the fight against global warming because gas energy releases less carbon. On yet other occasions it said that world unconventional and deep offshore stranded gas reserves were “outside OPEC's control”, so even if they were expensive to develop the game would be worth the candle!

The energy security rationale or fear paradigm has had a major role in firstly giving us too much energy at extreme high prices, followed by what is politely termed “the reverse hypothesis”. Of course energy shortage and rock-bottom energy prices are copybook unsustainable, but in the adjustment period will be corporate financial dynamite for Big Energy.

The potential for Big Energy, which already totally depends on government hand-outs and bail-outs in the nuclear and green energy sectors, moving to generalized asset value meltdown and playing the same role that “high street” banks played from 2008 onward, is now high and rising. Like the banks, Big Energy can become wards of the state living on hand-outs, pleading poverty and threatening corporate bankruptcy, lights out, investment collapse, mass layoffs of employees - and gasoline prices at the pumps, when its available, at anywhere from $3 to $15 a gallon. The price will of course depend on how their share price and corporate debt is doing, today. You know it makes sense!