Same Same, but Different

By Stephen Clayman · September 7, 2018

All,

Bethany McLean argued in a recent New York Times piece that some exploration and production companies who drill and frac horizontal oil and gas wells are on shaky financial footing due to the fact that most don't make money. This is a good argument and it makes sense! She is correct to note that most of the drilling is driven by companies that are able to acquire cheap debt from yield starved Wall Street investors. Berlin agrees that an increased money supply has forced interest rates lower than they ought to be. This decreased cost of capital allows more projects to pencil as viable.

What Berlin takes issue with is the fear mongering title of the article "The Next Financial Crisis Lurks Underground." Now, Berlin isn't an expert in synthetic collateralized debt obligations (but will taken an organic, gluten/dairy free, and pastured CDO of course, thanks), but here are some takeaways from the causes of the last financial crisis:

Mmmm...pastured, organic financial products above Oklahoma oil and gas mineral rights.

1. Banks lent money to subprime borrowers, but lied about the credit worthiness of the borrowers, and sold these mortgages downstream.
2. Companies sliced and diced these mortgages into complex derivatives. Few people understood the quality of the underlying assets.
3. These derivatives were given favorable ratings by the credit rating companies which qualified them to be purchased by firms thinking they were less risky than the actually were.
4. Insurance companies wrote polices on these derivatives and mis-priced the risk. Some of these insurance products were also make into derivatives.
5. Housing prices decreased and the pile of mis-priced risky assets collapsed.

I'm sure the usual commentators will point out that Berlin missed a couple key bullets, but those are the basics. What is similar in these situations (housing and oil) is that investors are looking for yield (but that is always the case) because debt is cheap. What is different in these situations is that the housing precipitated financial crises was fraudulent, opaque, and systemic. People lied about the quality of the assets, people turned these assets into financial products that few understood, and these products were sold to firms across multiple industries.

Berlin doesn't believe that the banks underwriting these oil companies' debt offerings are committing fraud. The oil companies are admitting in their financial reporting that they are losing money. Yet folks are buying these bonds anyways as the risk premium is apparently worth it. So while it is bad for the equity owner when the company loses money, it isn't necessarily bad for the management team (who always seems to be paid well), and for the holders of the debt if they are confident that the company can continue to roll their notes forward.

These bonds also do not appear to have been turned into derivatives and sold across multiple industries. For these reasons, Berlin believes that if in fact oil producers do go belly up (as they do from time to time), it will not cause an international financial crises like we saw in 2008.

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Berlin