Are we entering a commodities-led GFC?

Regular readers will know that I’ve been keeping tabs on the Loneliest Man at Davos, the Oliver Wyman analyst that in early 2011 predicted a second round GFC triggered by a commodity crash:

John picked up the phone. It was the bank’s legal counsel, Peter Thompson, calling. He had dramatic news. Garland Brothers, one of the world’s oldest banks, would declare bankruptcy tomorrow. As he lay there in his spacious air-conditioned bedroom, unable to return to sleep, John tried to reconstruct the events of the last four years…

During phase 1 we distinguish between two sources of demand affecting commodities prices: demand for use in the production of other goods (“real” demand) and demand for the purpose of price speculation (“speculative” demand). There are three major groups of players in our scenario. Firstly, there are economies, such as Latin America, Africa, Russia, Canada and Australia, which are the largest commodities producers. Secondly, there is China, which is now the world’s largest commodity importer. Thirdly, there are the developed world economies, such as the US, which are pumping liquidity into the financial system through their loose monetary policies.

As with any bubble, our scenario contains a compelling narrative that allows investors to convince themselves that “this time is different”. In this case it is a story of strong economic growth coming from China creating a sustainable increase in demand for commodities.

However, it is already apparent that increasing commodities prices are also creating inflationary pressure in China, which is exacerbated by China holding its currency artificially low by effectively pegging it to the US dollar. This makes commodities look like an attractive hedge against inflation for Chinese investors. The loose monetary policy in developed markets is similarly making commodities look attractive for Western investors. This “commodities rush” is demonstrated in the right-hand chart below, which shows the asset allocations of European and Asian investors. A recent investor survey by Barclays also found that 76% of investors predicted an even bigger inflow into commodities in 2011.


Based on the currently inflated commodity prices, commodity producers in countries such as Brazil and Russia have clear business cases for investing in projects to dig more commodities out of the ground. As competition to launch such projects increases, the costs of completing them also starts to rise, with the owners of mining equipment and laborers capitalizing on the increased demand by charging higher rates. Because a portion of the demand for the projects is not coming from the real economy, an excess supply of mining capacity and commodities will be created.

As with previous asset bubbles, we expect much of the debt financing for these projects to come from banks. And much of this bank financing is likely to be supplied by Western banks that are eager to preserve their diminishing return-on-equity and need to find lending opportunities that are sufficiently lucrative to cover their own increasing cost of funds. The balance sheets of life insurers will play a supporting role here, as insurers look for long-term investments that can match their liabilities and seek to earn additional illiquidity premia.


Well, that’s pretty much what happened.

Now, switch to the present. Brent was down another 3% to $61.47 on Friday night:


Friday’s cause was a cut in 2015 demand estimates by the International Energy Agency, from the FT:

The IEA, the wealthy nations’ energy watchdog, said in its closely watched monthly report that global oil demand will grow by 900,000 barrels a day in 2015 — 230,000 b/d less than the prior month’s expectations — to 93.3m b/d.

Relentless US production combined with Opec output that exceeded estimates has coincided with a demand slowdown in China and a weak European economy, sending oil spiralling lower.

“It may well take some time for supply and demand to respond to the price rout,” said the IEA.

At this price (WTI $58), some 80% of US shale is uneconomic, according to Morgan Stanley:


Remember, though, that includes capital costs, which are sunk. The real marginal cost for existing wells is somewhere down around $20-30, once firms are restructured.

So, at this stage, rather than shutting wells, what we would expect to see is stress in shale debt and, voila, high yield energy bonds are more aflame by the day:


Back to the Loneliest Man at Davos, lets make some comparisons with the Global Financial Crisis. In late 2007, as US house prices were falling, debt markets began to shut for those that financed housing projects. The US Fed stood by expecting the housing market to clear without too much difficulty given sub-prime was a relatively small segment of the market. It considered sub-prime risks to be contained and, although it began cutting interest rates, risk was considered to have been healthily spread via derivatives.

What happened instead was that the risk had become opaque and filtered through to everyone  and nobody, and as housing debt soured counter-parties to the debt began to wonder who held what. Trust progressively broke down, more lending was pulled, asset prices fell further, so on and so forth. The feedback loop ended in a virtual worldwide bank run.

The analogy with today is unsettling. The sub-prime market this time is US high yield energy debt. It is a relatively small segment of the US junk bond universe so the Fed is standing by actively considering rate hikes on the assumption that the shale market will clear relatively easily. They’ll probably be right.

However, the risks that shale debt is only the core of a rising bad debt problem for financial markets appears to be rising. The broader US corporate bond market is also seeing new selling, from the FT:

Investors are fleeing the US junk debt market as a sell-off that started in low-rated energy bonds last month has now spread to the broad corporate debt market amid fears of a spike in default rates.

The sharp drop in energy bond prices has helped push average yields on broad junk debt near the 7 per cent mark for the first time since June 2013, according to Barclays indices. The jump in yields come as redemptions from mutual funds and ETFs buying the securities more than doubled in the past week, to $1.9bn, according to Lipper.

…“The junk bond market is having a hard time and the pressure will continue,” said Michael Kastner, managing principal at Halyard Asset Management. “There are no real buyers right now and mutual funds will keep seeing redemptions.”

…Bankers, traders and regulators are concerned that strong buying over the past five years may be masking so-called “liquidity” issues in the vast corporate bond market that could come back to haunt them during a big sell-off.

The spread on Barclays US investment-grade corporate index has risen to 130 basis points, far surpassing its low of 97 bps reached in July this year and indicating weakness in the market.

Here are the US high yield and investment grade bond markets:


Selling, yes, but so far contained in both markets.

The other markets where contagion is more obvious are the oil producing states’ debt:


Other than Russia (and Venezuala), also contained so far.

We can draw a few conclusions, then:

  • we are still in the early days of the shakeout and the blowout in spreads is so far small;
  • as well, the falling oil price should still boost other parts of the global economy and markets and offset the damage done to oil producers, helping the oil price to stabilise via improved demand;
  • but, there are parallels with GFC debt dynamics and having frozen once it’s easier for markets to do it again. At the end of the day, markets are made up of people and if the damage to oil-related debt is enough, it could reach a tipping point where fear and contagion runs out of control. This could take the form a “credit event” as a bank or big leveraged player in markets becomes insolvent on the rising bad debt;
  • the Fed can end this quickly if it wants to, up to that tipping point, if it stands behind market liquidity with more QE, which will reassure that oil won’t fall too far and transform fear into reflation greed. The case for any early tightening in the US is gone. Right now I’d say market conditions suggest no bias to cut or to raise. Any move to renew QE will require much greater market chaos;
  • the danger therefore is that, like 2007/8, the Fed does not move fast enough and oil-debt contagion gets out of control before it acts, dragging in banks that have loaned money to marginal oil plays and their sovereigns, a al the loneliest man in Davos. If that happens all bets are off with an oil-related debt freeze that would overtake the entire commodity complex and swiftly crush excess supply everywhere via a global recession.

Needless to say, Australia would not fare well in this final scenario. The major LNG projects that saved the nation from the GFC would suddenly be at the centre of renewed global crisis. Today, the LNG contract price estimate is at a new low of $9.19:


Far below breakeven for all of the seven recent projects and deeply in the red for the QLD three, which average around $12mmBtu breakevens. That includes the sunk cost of building the plants, so the marginal costs are more like  $7-8mmBtu. If we get that low, gas export volumes will begin to fall.

If this shakeout really gets going, it is also fair to expect that the contracts underpinning the projects will come under intense pressure if not dissolve, exposing all to a falling spot price. We are already seeing some exit rumbles stuff from Sinpoec vis APLNG. It is unlikely that projects will stop producing given the marginal cost is around Brent $50-55 equivalent (and much lower for some of the cheaper gas), but changes in ownership at heavy discounts are very likely. On the upside, as global oil shakes out, the projects will have one huge advantage – they are built – so as debt and equity tighten, prospective competitors will disappear in droves.

It must be said that in the worst case, broader commodity debt would also be under such severe strain that the marginal players in all commodities would be at risk of simultaneous, catastrophic failure. Iron ore is the obvious candidate for accelerated and very serious fallout.

Without putting too fine a point on it, for Australia the scenario is a rerun of the 1890s depression, which followed the gold rush and Melbourne land boom driven by a proliferation of externally financed non-banks, culminating in a huge bust as offshore funding was cut off. This time around, Australian bank debt would seize up under the triptych of pressures of the general rise in global bank spreads, a sovereign rating downgrade as commodity tax income crashed and rising unemployment triggering falling house prices.

At this point a cycle that spins out of control in this way remains a tail risk, but there is no mistaking the structural change that is driving the commodity deflation and giving it a certain inevitability. We’re already well into shakeouts across much of the complex. The vital question is not if it gets worse but how fast does it do so? Will it happen at a pace that we can handle, as it has so far, and spread the pain over 5-10 years, allowing us to rebuild other non-resource tradables as a growth offset? Or, does it happen all at once, in a mighty cleansing?

As we end 2014, the answer to that question boils down to one more: is oil too-big-to-fail?

That’s my last post for the year. Have a merry and safe Christmas and I’ll see you mid January for one Hell of a 2015! 

Houses and Holes

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