Cai Jin

Oil rout raises fear of another global meltown

Analysts see parallels with 1997 financial crisis but Asian economies are stronger now

It may be surprising to think that cheaper oil could put financial markets at risk and a sharp drop in crude prices could pose real dangers for investors next year.

This is despite the many benefits lower oil prices bring to consumers, including less pricey petrol.

Crude prices have plunged by 67.8 per cent over the past 18 months, falling from US$115.71 a barrel in June last year to US$37 last week, or near the lows reached at the depth of the global financial crisis seven years ago.

This has wiped out an estimated US$1 trillion (S$1.4 trillion) in market value of oil-related stocks across the world as investors flee the sector.

The pain is not confined to major oil companies. In Singapore, the formerly buoyant offshore and marine sector, which services oil majors in their exploration and production activities, has been hard hit as well.

The FTSE ST Oil and Gas Index has plunged 35 per cent since January, well ahead of the 15 per cent loss registered by the benchmark Straits Times Index.

Among the biggies, Keppel Corp has lost $4.45 billion in market value, while Sembcorp Marine's market capitalisation has plummeted by $3.1 billion.

The pain looks unlikely to end any time soon, with sentiment souring further in the past two weeks as fresh worries hit the market - Opec members failing to agree on a production ceiling; prospects of more Iranian crude exports swelling the glut; and a warm winter lessening the demand for oil.

Analysts are also anticipating that oil prices will stay lower for a longer period than expected as increasing consumption fails to match the increase in supply. Ratings agency Moody's, for example, believes that the demand and supply will not reach equilibrium by the end of the decade. Worse, oil majors are taking another axe to their capital expenditure to conserve cash in a bid to protect the attractive dividend payouts they make to shareholders. In quick succession, US oil major Chevron announced that it would be slashing capital expenditure next year by 24 per cent to US$26.6 billion, while ConocoPhillips, another US oil major, said its capital budget for 2016 would be cut by 25 per cent to US$7.7 billion.

This is likely to cast a pall on the local offshore industry, where more deferrals of delivery of vessels and provisioning by shipyards are anticipated as clients are unwilling or unable to pay, due to cashflow problems. But the biggest worry is the similarities between now and 1997, when Asia was engulfed by a financial crisis.

Then, like now, oil prices had crashed by nearly 60 per cent from the start of 1997 to the end of 1998. One fallout was a soured appetite for risk.

The spread of high-yield bonds widened by about 4 percentage points, while spreads for junk bonds increased by 6 percentage points above ultra-safe US government bonds.

There is another superficial similarity worth highlighting - the strengthening of the US dollar in the flight to safe-haven assets. This, in turn, unleashed the biggest financial storm in Asia in decades as currencies such as the Thai baht, Indonesian rupiah and Malaysian ringgit crashed against the greenback.

History may not repeat itself as Asian governments have learnt their lessons well and ring-fenced their economies with huge piles of foreign exchange reserves to prevent a repeat of the Asian financial crisis. They have also weaned themselves off the habit of pegging their currencies to the greenback and borrowing overseas.

The problem is that non-financial firms have stepped into the breach, issuing US-dollar-denominated bonds in the billions that have been snapped up by yield-hungry fund managers as the zero interest- rate environment sucked investors into all manner of high-risk assets.

A major beneficiary had been the US shale oil firms ,whose US$350 billion investments in the past six years were mostly financed by these markets.

But fears of further rate hikes by the US central bank - it lifted rates for the first time in nearly a decade last week - are making investors nervous and they are demanding their money back, but their managers are unable to liquidate their positions fast enough to deliver. This has caused three funds in New York specialising in junk bonds to face a wave of redemptions, and forced two of them to close down in the past fortnight. The standard explanation for their plight is that they are outliers, loading up not just on junk but the junkiest of the lot, which seem so close to distress that they are essentially worthless.

But the big worry is that they may just form the tip of the iceberg, with more funds in danger of closing as the default rate for speculative- grade companies shoots up due to their inability to service their debts.

How bad is this likely to be? So far, in our own backyard, what we see is a number of companies seeking to amend the covenants they agreed to when they took up loans in good times.

But as investors become more nervous, they may not be agreeable to such amendments as such breaches will allow them to accelerate the repayment of the loans.

There is a further worry - the pain now being felt by heavily indebted US gas drillers may spread to other sectors as investors reassess the risks they are taking with the junk bonds they bought.

Will this trigger another financial crisis on the scale of the one seven years ago? So far, the answer is no. Banks were forced to clean up their proprietary trading desks after that meltdown and this has lessened the systemic risks - the fear of one bank failure causing others to fail as well because its balance sheet is stuffed with toxic bonds.

But the fissures now observed in the US junk bond market may be a harbinger of worse things to come. A combination of cheaper oil and higher real interest rates may be toxic for the low-grade corporate and emerging markets.

A version of this article appeared in the print edition of The Straits Times on December 21, 2015, with the headline 'Oil rout raises fear of another global meltown'. Print Edition | Subscribe