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The Oil-Drenched Black Swan, Part 2: The Financialization of Oil
Submitted by Charles Hugh-Smith of OfTwoMinds blog,
All the analysts chortling over the "equivalent of a tax break" for consumers are about to be buried by an avalanche of defaults and crushing losses as the chickens of financializing oil come home to roost.
The pundits crowing about the stimulus effect of lower oil prices on consumers are missing the real story, which is the financialization of oil. Financialization is another word that is often bandied about without the benefit of a definition.
Here is my definition:
Financialization is the mass commodification of debt and debt-based financial instruments collaterized by previously low-risk assets, a pyramiding of risk and speculative gains that is only possible in a massive expansion of low-cost credit and leverage.
That is a mouthful, so let's break it into bite-sized chunks.
Home mortgages are a good example of how financialization increases financial profits by jacking up risk and distributing it to suckers who don't recognize the potential for collapse and staggering losses.
In the good old days, home mortgages were safe and dull: banks and savings and loans issued the mortgages and kept the loans on their books, earning a stable return for the 30 years of the mortgage's term.
Then the financialization machine appeared on the horizon and revolutionized the home mortgage business to increase profits. The first step was to generate entire new families of mortgages with higher profit margins than conventional mortgages. These included no-down payment mortgages (liar loans), no-interest-for-the-first-few-years mortgages, adjustable-rate mortgages, home equity lines of credit, and so on.
This broadening of options and risks greatly expanded the pool of people who qualified for a mortgage. In the old days, only those with sterling credit qualified for a home mortgage. In the financialized realm, almost anyone with a pulse could qualify for one exotic mortgage or another.
The interest rate, risk and profit margins were all much higher for the originators. What's not to like? Well, the risk of default is a problem. Defaults trigger losses.
Financialization's solution: package the risk in safe-looking securities and offload the risk onto suckers and marks. Securitizing mortgages enabled loan originators to skim the origination fees and profits up front and then offload the risk of default and loss onto buyers of the mortgage securities.
Securitization was tailor-made for hiding risk deep inside apparently low-risk pools of mortgages and rigging the tranches to maximize profits for the packagers at the expense of the unwary buyers, who bought high-risk securities under the false premise that they were "safe home mortgages."
The con worked because home mortgages were traditionally safe. Financialization did several things to the home mortgage market:
1. Collateralized previous low-risk assets into high-risk, high-profit financial instruments
2. Commoditized this expansion of debt and leverage by securitizing the exotic mortgages
3. Built an inverted pyramid of leveraged speculative debt on the low-risk home mortgage
4. Used the Federal Reserve's vast expansion of liquidity and credit to originate trillions of dollars in new debt and leveraged financial instruments.
Consider a house purchased with a liar-loan, no-down payment mortgage. Since the buyer didn't even put any cash down or verify stable income, there is literally no collateral at all to back up the mortgage. The slightest decline in the value of the home will immediately generate a loss of capital.
Now pile on derivatives, CDOs, etc. on the inverted pyramid of risk piled on the non-existent collateral, and you have the perfect recipe for financial collapse.
Like home mortgages, oil has been viewed as a "safe" asset. The financialization of the oil sector has followed a slightly different script but the results are the same:
A weak foundation of collateral is supporting a mountain of leveraged, high-risk debt and derivatives. Oil in the ground has been treated as collateral for trillions of dollars in junk bonds, loans and derivatives of all this new debt.
The 35% decline in the price of oil has reduced the underlying collateral supporting all this debt by 35%. Loans that were deemed low-risk when oil was $100/barrel are no longer low-risk with oil below $70/barrel (dead-cat bounces notwithstanding).
Financialization is always based on the presumption that risk can be cancelled out by hedging bets made with counterparties. This sounds appealing, but as I have noted many times, risk cannot be disappeared, it can only be masked or transferred to others.
Relying on counterparties to pay out cannot make risk vanish; it only masks the risk of default by transferring the risk to counterparties, who then transfer it to still other counterparties, and so on.
This illusory vanishing act hasn't made risk disappear: rather, it has set up a line of dominoes waiting for one domino to topple. This one domino will proceed to take down the entire line of financial dominoes.
The 35% drop in the price of oil is the first domino. All the supposedly safe, low-risk loans and bets placed on oil, made with the supreme confidence that oil would continue to trade in a band around $100/barrel, are now revealed as high-risk.
In the heyday of mortgage financialization, exotic mortgages were tranched into securities that were designed to fail, to the benefit of the originators, not the buyers.These financial instruments were sold with the implicit understanding that they were only low-risk if the housing bubble continued to expand.
Once home prices fell and the collateral was impaired, it only made financial sense for borrowers to default and counterparties to refuse to pay until their bets were made whole by another counterparty.
The failure of one counterparty will topple the entire line of counterparty dominoes. The first domino in the oil sector has fallen, and the long line of financialized dominoes is starting to topple. Everyone who bought a supposedly low-risk bond, loan or derivative based on oil in the ground is about to discover the low risk was illusory. All those who hedged the risk with a counterparty bet are about to discover that a counterparty failure ten dominoes down the line has destroyed their hedge, and the loss is theirs to absorb.
All the analysts chortling over the "equivalent of a tax break" for consumers are about to be buried by an avalanche of defaults and crushing losses as the chickens of financializing oil come home to roost.
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Financialization....the conversion of lead into gold, a debt into an asset
"We foreclosed on some folks loans".
https://www.youtube.com/watch?v=-DT7bX-B1Mg
I recall reading that many of the large oil companies have hedged their oil prices for the next two to three years and don't much care about the current price.
So who will take the hit for the decline in oil prices? Go the the bathroom and look in the mirror. Somehow it will be you sucker.
The best part of this article is that it highlights the need for a good definition of "financialization". This is the concept that is destroying (optimistic) / has destroyed (pessimistic) the US economy. My attempt:
Financialization is the creation of debt/leverage instruments based upon real-world commodities.
From that simple definition, the problem of the past thirty years has been that so many more of these instruments have been created than the value of the commodities that provide their collateral could possibly cover. The only people who benefit from this process are those who get out when the instrument still has its initial "worth", i.e. the bankers. After that, only a shell is left, with paper inside that is on a fundamental level, worthless. That is the part that "We, the People" get. As real goods and production are increasingly stripped out of our economy in the west, all that remains is this churning paper back and forth. This is why people are increasingly anxious. We all know that all this "GDP" or "economic activity" is not making anything. It's a mirage.
Financialization: the death of a society. We are not the first down this path. End-stage Romans would have been able to tell us a thing or two...
All this crap was created by congress. Have your lobbyist go to the congress and tell them they need the laws changed to "help the little people" and lay some big money on them and then make sure your lobbyist is directly involved in writing the bill and lean on the congress to pass it and the president to sign it. Now you can open up a new feed trough for the Wall St. piggies to feed. when the corpse starts smelling, go to congress and tell them you need a bill........
each time something is financialised there must be a fee involved - who is going to do it for free??
now who do you think gets the fees, and who ends up paying them??
Those mortgages that were bundled averaged a 50% markup on capitalization into bonds.
Then they got really greedy, and sold them multiple times,42 times in Bear Stearns case.
Nice work in you can do it without jail time.
Money changers collect, goyim pay.
I really hope this is sarcasm. It is the ability of congress to write laws that is at the heart of the problem. They do not represent us and never have. Politicians are the worst kind of vermon on the planet, right next to lawyers. People will always be self interested and granting others more power over you only exacerbates the problem. Be your own leader, walk your own path, and abide only by natural law. http://newamerica-now.blogspot.com/
oil...
The black death the tycoons have at the ready.
But when the clock strikes twelve at midnight all the Cinderella gold will turn back to lead.
Financialization = fraud throught the economy. Organized crime figured this out generations ago.
1. Misprice risk
2. Sell something you don't own, or sell the same thing to multiple people.
3. Insure something you don't own and burn it down.
4. Buy a judge or a politican to look the other way.
There, saved you an $80,000 MBA.
Thx duo, I always knew MBAs were overpriced. Do we all get a trophy now?
Financialization....the conversion of lead into gold, a debt into an asset...
Exactly! Or as was mentioned above:
"Financialization of oil?
This is news?
Or does CHS realize that this is ancient history? Honestly, this has been going on since the 1960's and 70's..."
Wasn't this an integral part of the Exxon Valdez "settlement" where investors bought shares of the then astronomical one Billion dollar fine in the hopes of selling their shares to another sucker down the road. It's as much a farce now as it was when JPM and Blythe concieved their first Rosemary's Baby.
http://thinkprogress.org/climate/2010/05/26/206077/jp-morgan-invented-cr...
In 1985, the Saudis opened the spigots to break the Soviet Union. Now who are they breaking?
The US. and Russia. and Venezuela. and Iran. and Syria. and Iraq. and ISIS. and Libya.
The Saudis are breaking the Saudis.
They are enriching the Chinese and Japanese.
Lower energy prices will make the tenant in the buy-to-rent real estate sector a better risk.
That was almost 30 years ago. The Saudis reserves are depleting. i wonder if this is a last ditch play by them. Maybe the vile House of Saud is worried that shit will fall apart very fast as the oil gets used up.
I would love to be a fly on the wall to know what is really happening. I hope the House of Saud scum is taken down. They are vermin.
Some people will have access to consumable calories and all the resources necessary for a decent standard of living. Most will not.
Same as it ever was...
in 2009 when FASB 157 did away with mark to market and replaced with mark to model ... MBS suddenly started looking better
a barrel of oil is a barrel of oil
if the collateral (oil) tanking that backs loans ... how will banksters hide it??
surely, they'll think of something ...
No they won't
And don't call us Shirley.
Yes, but so long as "mark to fantasy" accounting is still in play, it really doesn't matter does it? Oil prices went down 35% you say? They will make their inventory numbers 40% higher...
Centrals banker threw off their last chains in 1971. Amazing really...
When Accounting is debased to the degree it has been, it can be used to show whatever it is needed to show.
Accounting is no physical science or engineering. It is part of the fictional science Economic umbrella. Voodoo Economics
This could be kind of a Lehman moment.
Waddya mean "kind of"?
Nothing matters anymore. The markets are dead.
Yawn - just change the market to market FASB again and let's inflate asstes held as colleteral to the make bleive levels in the past - problem solved
DXY back to near recent highs ... much to the consternation of those who - in the past few days - have written its demise on tap
nothing goes straight up or straight down...
bawk bawk?
This morning on the way to work a market dominant AM sports radio show was advertising oil partnerships as a great investment with up to 40% returns based on the continuing rise in oil prices--this ongoing increase in oil prices was repeated. I was stunned, really. How can they say that? Does the SEC do anything anymore?
Enjoy your shoeshine boy moments as long as they last.
Gonna get interesting.
Long Orville Redenbachers.
This is a job for SUPER Central Banker! (in to the dark pool goes mild mannered economist Yellin and out comes .... ta da..... a douche named dudley.)
Nice post CHS...
"equivalent of a tax break" . BFD,Americans have a few more bucks in their pockets and the asshole pundits expect them to rush and spent that on useless trinkets....
On the other hand....
https://www.youtube.com/watch?v=6M7miLPtPTc
The other side of this excess leverage issue is that some oil patch players will become distressed by their debt burden and could be picked up on the cheap by the majors. So, before the dominoes fall, there's likely to be a bit of rearranging of ownership. I suspect the majors will grow and the wildcatters will be dust in the wind.
check the price of WLL.
Good operator with good Bakken acreage. Very highly leveraged and getting killed in the market because of the debt. down much more than the E&P sector.
CVX and XOM will have some great opportunities if prices remain in the $60s for a year. World oil demand will continue to increase for a long, long time.
Whiting (WLL) has not hedged forward much of their production. they are adding the leverage on the balance sheet of Kodiak in the pending acquisition. This is why the stock has been hammered.
Incredibly simplistic arguments. Drillers can and are hedging oil at $100 out two years. Plus the IB's and large lenders are also hedging out.
Smith's analysis is simplistic. Though it is true that someone is long all the contracts the levered shale players have hedged forward. Who are these someones?
Probably hedge funds, banks, et al.
The US imported 2.8Billion BOE last year. A 30% price cut is around a $80Billion savings.
I'm guessing total junk bonds of all shale players are around $80Billion.
Nothing to see here. I love Charles H. Smith, but he is in over his head here.
Shit show of the week
I just want the shit to implode ..the people would be so much better off today if the shit would have just collapsed ...people would have learned survival ,do without shit we don't need ...didn't oil drop into the 30's ??
I don't think shit will ever get right in this country ...it had the chance and it is gone ...
I will say would I like a new car, boat , house nicer things in life...
Yes..I would be a liar if I said no... but a cotton t shirt , shorts and good food not the crap at fast food . Just good diet , a good way to be mobile a bicycle would do and just enjoy life ...a decent place to sleep like a hammock would suit me just fine and enjoy what was created by mother nature... not manufactured in a plant cept the bicycle..
Don't set your sights too high.
The Classic Comic Book Version
The President of the Powers That Be is sitting on his throne. when a lackey bows his way in to say "We'll be out of oil in 9 years, lord. What shall we do?
The lord ponders and decides that a great and huge recession will choke the chicken of demand.
"Now is the paucity of our petroleum made glorious glut by this triple-dip recession."
FIST BUMP EXEUNT CURTAIN
Fast forward to today where, in the words of Mad Ave, "Civilization has traded a headache for an upset stomach."
A World War will increase the demand/price for oil so Cheney can bail out his pals...how many oil companies are threatening to withhold campaign donations right now?
Those new tanks/jets/ships have to run on something
So . . . we have a Fed governor saying deflation is good? If it's so good, why the $Trillions in asset purchases since 2008? Wouldn't it be good also if the housing marketI guess what's good is to make sure the banks which own and control you get insulated from the impact of deflation on their highly leveraged balance sheets.
The central bank scam of the 20s and 30s repeats itself: inflate and encourage debt, deflate, scoop up liquidated assets. Ever increasing concentration of ownership.
".......Inflate and encourage debt, Deflate, scoop up liquidated assets......."
Indeed.....
I called it "set 'em up to knock 'em down", since I saw the first take down back in the seventies. They have been set up again. Almost time to knock 'em down. Suckers!
Financialization of oil?
This is news?
Or does CHS realize that this is ancient history? Honestly, this has been going on since the 1960's and 70's.
What the hell did you think the Petrodollar was all about? It is just one method of financializing a commodity.
The fact is that it has all been financialized. When you buy a stock from your retail broker, you don't know if they actually bought a stock for you. They may have just booked a stock entry for you, and then used your money to buy short contract in the very stock you thought you bought, turning your supposed stock purchase into a loser from day one.
But they don't really know whether the entity from whom they bought the short contract actually had any stocks to sell. The author of the short contract might have been naked shorting. In which case, your broker or market makers too are naked, and so on, and so forth.
That is why the markets are not markets. Because to have a market you have to have a buyer and a seller each of whom have something to trade. Financialization is the process of presenting something that is not yours as payement for something you intend to be yours. So, you don't know if the seller actually has something to sell, or the buyer has anything to trade for it.... Hence it is not a market, but a gambling house.
If you own 'assets' purchased from one of the world's stock casino's or futures' casino's you own nothing but some ink on an account statement until and unless you convert it into a real physical object in your possessionl And you will be shocked to the core when you learn what a tiny percentage of the 'assets' ever actually existed
Beautifully said.
What holds any complex economic system together is trust. That is a commodity that can disappear in an instant...
whoring for the Saudis again eh Tyler? In the REAL WORLD, people actually benefit from lower gas prices.
As already said: People benefit from lower house prices ....except when the housing market has been financialized. (try paying attention)
Organized crime is a beautiful thing when you can get away with it
It’s really simple and tragic, George Washington said it best: “Few men have virtue enough to withstand the highest bidder”.
GREED and American/British corporate fascist (merger of monopoly corporations with government) and their criminal EMPIRE are out to destroy humanity and the Rule of Law.
I like Charles Hughes Smith because he explains processes, which is very rare here on ZH. He describes the head bone connected to the neck bone. To often assertions are made without explaining why and how the author came to the conclusion. ZH authors assume that the readers are experts in the bond and futures market and do not explain how something is supposed to work and why and then describe how the current situation violates the intent of the basic process.
Also, there is virtually never a spell out of an acronym the first time it is used in an essay, which is a basic English writing convention.
Don't worry. I have been assured that taxpayers will not have to clean up the mess this time.
Oil in the ground has been treated as collateral for trillions of dollars in junk bonds, loans and derivatives of all this new debt.
Not to get all lawyerly, but is there any evidence of this claim? ZH articles are usually loaded down with ticker symbols or graphs illustrating instruments that are referred to in the text. This one doesn't identify a single one.
The geopolitics of energy pipelines are going to have a longer-term negative impact on Europe and are of the pieces of the energy puzzle. These are well worth the reading time. Europe, lead by the US, is screwing itself:
Russia, Turkey, China And Natural Gas Pipelines: Who Won? Who Lost? You Tell Me!
http://thenewsdoctors.com/?p=251085
If Europe Does Not Want To Carry Out South Stream…
http://thenewsdoctors.com/?p=251377
its all virtual reality. everyone at the treasury, federal reserve, to big to fail banks, they are all wearing "oculus" virtual reality head gear.
so as soon as the american public starts wearing oculus and enters the virtual reality world of financialization everything will be fine. the waters fine. everybody jump in and enjoy
No worries, the US taxpayer will bail them out. TaDa!
At least the "peak oilers" have STFU.
When financial problems occur in the energy sector it is often accompanied by political instability and sometimes her ugly sister war. As a rule the economy loves stability, bottom-line dropping oil prices means more risk for an already shaky world economy. All this is being complicated by the recently strong dollar. The dollars strength and the rising American stock market could also be taken as a sign of an unstable global economy.
When a strong shift in currencies occurs someone usually gets hurt and this can lead to bankruptcy, default, or contagion. A great deal of the shadow banking world overlaps and falls into the grey world of derivatives. The total derivatives market has grown to a massive size. It includes hundreds of trillions of dollars in over-the-counter non-reported agreements and private contracts and is estimated to be over 20 times larger than the global economy. Everyone paying attention knows that even a slight problem in a market this size could collapse the whole economic system. The article below delves deeper into the problems caused by falling oil prices.
http://brucewilds.blogspot.com/2014/11/dropping-oil-prices-increase-risk-to.html
Low debt high cash flow oil companies simply purchase smaller high debt low cash flow oil companies. Then the larger companies ratchet the prices back up.
Big deal. Seems like there's nothing to see here.