Candidates for tail risk in 2015
Having just given you a mental model for thinking about tail risk, the natural next analysis is where the tail risk might be. Here are a few candidates.
The first risk is in the oil patch. I first brought this them up in October regarding zero rates, resource misallocation and shale oil. The thesis here was that a combination of high oil prices and low nominal rates has made investment in unconventional oil much more attractive in the last 5 years. The result was an increase in supply to match the increase in demand coming for emerging markets without oil prices rising further still. However, when emerging market growth slowed, many analysts believe that eventually the supply became more than was needed. And the result was a decline in the price of oil.
The questions about this thesis are why the price oil declined so much later than industrial commodity prices and why it has done so abruptly. I believe the late and rapid decline is due principally to the huge net long position in the oil futures market that had built up by July. This position allowed oil prices to remain elevated after industrial commodities had dropped and also meant that the drop was more rapid. If this thesis is true, it would also mean that we are likely to see an overshoot to the downside as not only do net long positions get liquidated but the market builds a net short position in oil futures. Let’s see.
At a minimum, OPEC countries are now saying quite firmly that it will not cut production at $60 or even at $40 a barrel. That’s a huge white flag that should put downward pressure on the oil price. Given the long oil position was not a hedge for producers, it is likely that some bank or hedge fund players are sitting on massive losses right now because this is a big market and cannot decline by 40-50% without someone taking a massive blow to capital. Yves Smith speculated on just this today, wondering whether the US derivatives legal fight had some basis in a need to protect banks from the fall in oil prices. This is clearly speculative but the black swan event here would be a failure of major size creating contagion.
High yield and leveraged loans
The thesis I made in October on oil was that the decline was not only negative for the oil market but would have a negative impact on oil funding markets like high yield and leveraged loans. Let me spell this out in detail. I wrote specifically that, “the Japanese experience with zero rates and risk spreads told us that while safe assets were firmly anchored by the central bank’s actions, risk assets decoupled from safe assets in economic downturns. What we saw in 1997-98 and subsequent Japanese downturns was that the full force of market dislocation fell onto risk assets in the form of higher risk spreads without any yield relief because of the central bank’s inability to cut rates. For shale oil producers, this should mean a gapping up of rollover payment terms, presenting those companies with a brutally different funding environment.
“Second, to the degree investors know the IRR of these companies based on previous funding rounds, companies could get locked out of funding markets altogether as the return on investment won’t exceed the interest rate on loans. This would be a sudden stop of debt financing to the shale market, which would either require more equity funding or it could usher in a crisis of epic proportions into the shale oil sector.
“Third, unless companies can lower breakevens on exploration profitability, the $80 crude environment could be catastrophic to profitability of shale oil production because the lower revenue fundamentally changes the IRR on these investments. My understanding based on conversations with people familiar with this market is that many projects are not profitable below the $80-90 level.
“As a result, what I am looking to see how long this slump in prices last. And what I expect to happen is that if it lasts more than a few weeks, we are going to see liquidity in the shale oil funding market dry up and then the companies with the worst cash flow positions will run into trouble and default. I don’t think we are there yet. But the drop in price has been so abrupt and so extreme that it will have caught everyone off guard.
“Now notice that QE is less potent here. It’s not as if the Fed could wave it’s magic QE wand and get risk spreads back down, especially if the real economy heads south. Without the interest rate lever then, the central bank has much less control over asset markets because they will be completely driven by term and risk premia instead of by interest rate cuts or hikes. This is where QE and forward guidance are much less useful than interest rate policy.
“What we should be concerned about here is that, just as with subprime mortgages, this is not a particularly big market but one with interconnections to others. The leveraged loan and high yield market could be affected and other riskier US debt markets like student loans or auto ABS could be affected by sentiment. Right now, it is still early days. So the oil price might even recover. But the abundant liquidity of zero rates, resource misallocation and shale oil simply do not mix.”
We are well below the $75-80 a barrel level where the negative scenarios play out and so we have begun to see them play out. For example, just as I worried in October, junk bond worries have spread beyond oil. Every single junk bond sector in the JPM index registered losses in the five days to 9 December, according to the Wall Street Journal. Moreover, the huge losses in equity markets last week are an outgrowth of the problems in the oil sector. Given how well the US economy is doing now, this is a clear sign of contagion.
US capital investment
Andy Lees of the Macro Strategy Partnership wrote earlier today that S&P has calculated that energy now accounts for 41% of North American capital expenditure. This includes shale, oil sands, energy infrastructure, and everything in between I am assuming. Companies in the shale and oil sands and deepwater segments are cutting back because these are high cost endeavours. But so too are large operators like Conoco Phillips and BP. While the loss of income for producers is a net gain for oil consumers and more than that because the US is a net importer of oil, the concern here is on capital expenditure as a line item in the national income and product accounts. This measure is going to fall and I believe so quickly that GDP estimates will not capture the full reduction until we see revised data months later. In my view this will impact Q4 2014 numbers but more so 2015 numbers.
From here it is harder to deduce what the impact will be because the sensitivity of the Fed’s reaction function is unknown since the Fed is making it up as it goes along. In worst case scenarios, the drop in capex will have a general negative impact on market tone and pull down equity multiples.
We are seeing weakness in oil patch municipal finances in the US. And I reckon the same is probably true in Canada as well. Here’s Reuters on the story:
In Houston, Texas, the first oil industry layoffs have been announced, with realtors there predicting a sharp decline, up to 12 percent, in home sales next year.
Alaska’s 2015 fiscal year budget revenue forecast will have to be lowered by almost $2 billion, according to Fitch Ratings, because of the sharp drop in the state’s forecast crude prices. That will widen Alaska’s budget gap to almost $3.4 billion, Fitch said in a Dec. 11 report.
States such as Texas, North Dakota, Alaska, Oklahoma and New Mexico are all likely to feel strains next year, Wells Fargo Securities municipal analyst Roy Eappen said in a recent report.
Meanwhile, household sentiment in Texas, Louisiana, Oklahoma and Arkansas where memories of the catastrophic 1980s oil crash are still fresh, weakened in October more than any other region, according to a report by Decision Analyst Inc. The Texas-based research company surveys monthly thousands of homeowners in the Census Bureau’s nine regional divisions.
And here’s a second from Reuters on Oklahoma froma few days back:
Oklahoma’s energy-related revenues are feeling the squeeze from lower oil prices and if the price remains low, it could hit income and sales tax revenues if energy workers have less money to spend, the state’s treasurer said on Friday.
Lower oil prices are expected to boost some states’ sales revenues, as they give people more discretionary spending power. That is tempered by the impact lower prices have on energy-focused states.
“We are beginning to see the signs of softening prices, but we’ve not yet seen the impact of these extremely low prices of below $70. That will take a few months to get in,” Ken Miller, Oklahoma state treasurer, said on the sidelines of the National Association of State Treasurers’ conference in New York City.
It is a contrast to North Dakota, benefiting from an energy boom, which is forecasting rebounding oil prices and a 23 percent jump in oil taxes.
Oklahoma’s monthly numbers for November show the first year-on-year decline in energy tax revenues for the state in 19 months although overall state revenues remained healthy.
Collections from its gross production tax on oil and natural gas slipped below prior year collections in November, down 5.3 percent year-on-year, Miller’s office said. It was the first monthly year-on-year decrease since April 2013. Still, personal income and sales taxes were healthy.
There’s not much to add here except that North Dakota is going to get caught out here. These are not the worst states from a municipal finance perspective. So the impact could be muted. But we should add municipal finance to the areas for potential tail risk in 2015 nonetheless.
Emerging market corporates
Although I wrote a piece on the dangers of a strong dollar and divergent monetary policy, a thesis I have yet to fully expand on is the emerging market corporate thesis. Raoul Pal spoke to us at Boom Bust on Friday and you can hear some of his views here. He makes the case for a strong dollar as being negative for emerging markets compared to developed markets. And right now, the dollar is strong and could strengthen from here.
Here’s the thesis. The United States is doing so well relative to the rest of the world that the monetary policy of the US central bank is going to diverge from other major central banks’ policy, strengthening the US dollar. Because the USD is the major global reserve currency and because the US economy is so large, the US dollar market for credit is so deep and complex, that foreign companies and countries often borrow in US dollars. When the USD rises, this creates a asset-liability mismatch that can lead to liquidity crises and bankruptcies, particularly in emerging markets. We have seen this time and again in the fiat currency age.
Because of the repeated crises of the past, foreign governments have had their central banks build up significant foreign reserves to protect their economies from crisis. Nevertheless, there are two vulnerabilities. First are countries with large current account and government funding needs like the so-called fragile five. We saw this crisis already as a mini-crisis early in the year. These actors may have toughened up enough to prevent a recurrence. However, the corporate borrowers without sufficient currency hedges or hard currency revenue streams could find themselves in dire straits. This could negatively impact emerging market funds, for both equity and bonds. As I am still developing this thesis, I won’t say much more but I will flesh it out in greater detail in the weeks ahead.
One country that I am concerned about is Russia, given the freefall in their currency. The Russian state should be ok because it has a hard currency revenue stream due to huge energy exports. And the central bank has massive liquidity in foreign reserves at its disposal. Russian corporates face different problems though, in part due to sanctions that have cut off US dollar markets for funding. This could create a liquidity crisis in Russian corporates. Nevertheless, I am sanguine about Russian state debt. It is probably still too early to get into Russian equities, though exporters Gazprom, Lukoil and Surgutneftegaz with ridiculously low P/E ratios and hard currency foreign revenue, are good bargains I think.
Canada and Australia
Another place to look for problems is Canada because of the nexus of high household debt, high house prices and leverage to the energy sector. In Canada where mortgages are recourse loans, there is no walkaway opportunity which can bolster consumer spending if the economy gets hit by a downturn due to oil and gas profits and capex. Instead, given high household debt and high house prices, we should expect a weak housing market to develop that would bring on significant consumer deleveraging and in a worst case scenario would lower house prices, making the deleveraging more severe. Australia has similar dynamics, though it revolves more around the industrial commodities space. The household debt and house price eleveation are problematic in Australia as well.
I am going to stop here. As I get more ideas I will add to this list.