Oil Industry Faces Credit Crunch Copyright © 2023 Energy Intelligence Group
The oil industry seems to be once again ignoring key and obvious signs of jeopardy from external sources. This time its survival may be at stake, as reverberations from the collapse of Silicon Valley Bank continue to spread through an already-stressed global financial system and still threaten to overwhelm it. Oil executives and ministers ignore the danger of being sucked under by a sinking financial system at their own peril. Governments and central banks will save the financial system, as they often have. No one, though, will throw a life vest to the oil industry. And even if a major financial shock is averted in the near term, the effects of this crisis will still be felt for years to come in much tighter credit conditions.
The global financial system is in trouble as March ends. Bankers have failed to adjust their reserves for the rise in interest rates, and deposits have flown as their owners have realized this. They are thus unlikely to lend to even the most creditworthy customers and are instead slamming lending windows shut, slashing credit lines, and rejecting loan applications from long-standing patrons. The banks that survive will be those that lend the least.
The “bureaucratic and process-oriented” nature of bank examination has been key to these meltdowns. Regulators were slow to recognize Silicon Valley Bank’s fragility. But another far more important development is the newfound ability to move money with a smartphone. In past times, deposit outflows were modulated by how fast tellers could dispense cash or ATMs could be refilled. Customers who wanted to close their accounts or move large sums had to visit their branch office. That gave regulators and executives time to craft a plan to calm anxious patrons.
Flight to the Fed
A further headache for central banks and oil traders is that the money being withdrawn from US commercial banks is moving to the Federal Reserve rather than other banks. This development constitutes the greatest threat to the economy and those in the oil industry.
Research by economists at the Federal Reserve Bank of New York shows that, by increasing its discount rate, the Federal Reserve Board gave money market funds the incentive to move funds to the Fed through “reverse repurchases” or “reverse repos.” Funds transferred to the Fed pay 4.8% now, up from 0.05% a year ago. And between March 2021 and October 2022, money market balances held in reverse repos rose from “a few billion” to over $2.2 trillion, according to the Fed economists. In the following six months, the flow to money market funds increased by another $500 billion. Perhaps half of that occurred in the last few weeks.
This increase was mirrored by a decline in bank reserves. From the end of December 2022 to the week ending Mar. 16, 2023, bank deposits declined by almost $500 billion or 3%. Deposits at the 25 largest banks dropped by $200 billion or 2%. The problem for the economy is that the money going to the Fed cannot be lent by banks to customers to, say, buy oil or purchase a car. Shorn of deposits, banks will need to fund loans through commercial markets where interest rates are now much higher. This will lead, in turn, to higher lending interest rates and stricter loan standards.
European Jitters
Banks in Europe are less exposed than in the US, but can’t ignore the crisis, as Credit Suisse’s failure shows. Contagion from that has already spread to Germany. The problem relates to AT1 bonds — an obscure financial instrument also known as “contingent convertibles” or “CoCos,” which systematically important banks are required to issue. CoCos shift the cost of a bank failure from governments to the private sector. They are specifically designed to act as a buffer for banks if capital levels drop below a specific threshold. The reward to investors from these long-term euro-denominated bonds is quite large today compared to rates on long-term bonds issued by European governments. But with that comes the risk that the bonds will be converted to equity or, alternatively, get wiped out.
A Swiss decision to wipe out the holders of Credit Suisse bonds has some worrying now that banks may no longer be able to use these instruments to meet the reserve requirements mandated by central banks. Goldman Sachs has reportedly advised its clients that it was no longer possible to assess credit spreads on AT1s. Following the Swiss action, the prices of AT1 bonds issued by Deutsche Bank and others also fell. These declines emphasize the fact that European banks, like their US counterparts, will face difficulties raising operating funds. The consequence is that lending will be cut, and the cost of lending will rise.
