Dallas Federal Reserve President and Chief Executive Officer Robert Kaplan, spoke at a recent meeting at the University of Houston. He declared that oil industry chief executive officers (CEOs) have bigger worries than national monetary policy. Quite possibly Mr. Kaplan doesn’t understand the importance low interest rates have been for the energy industry and how adjusting those rates may impact the outlook for the business. Mr. Kaplan was quoted in the Houston Chronicle saying, “If I’m in the energy industry, there are a lot of things that I’m agonizing about right now and staying awake at night about right now. I don’t think Fed monetary policy should be one of them.”
For virtually all of this year, Federal Reserve board members and chair Janet Yellen have wrestled with when is the right time to abandon their zero interest rate experiment that has dominated the nation’s monetary policy for most of this century. While most people focus on the zero rate policy created in response to the 2008 financial crisis, they often forget that abnormally low interest rates were used earlier to offset the recessionary effects following the dot.com stock market bust of 2000-2001, which was later followed by the after-effects of the 9/11 terrorist attacks. While the Federal Reserve under then Chairman Alan Greenspan did not drive short-term interest rates to zero, it did drive them to 1% in an attempt to take away the incentive for Americans to put their money into savings accounts and instead encourage them to spend it and boost economic activity.
The low interest rate environment of the early 2000s was credited with contributing to the great housing bubble that was initiated by the expanded government incentives under President Bill Clinton promoting universal homeownership. The housing boom that ensued contributed to the belief that the American economy was doing well and would continue to grow after the terrorist attacks in September 2001. The housing bubble’s growth coincided with the early successes of the American oil and gas shale revolution and the explosion in global oil consumption in 2004. All of these forces combined to create the “perfect storm” for fiscal, monetary and energy policies that were the seeds of the 2008 global financial crisis.
While the drop in the federal funds rate was dramatic from late in 2000 to the end of 2001, the sluggish response of the American economy was thought to need further stimulus from the Federal Reserve who took short-term rates down to 1% by mid-2003. It kept rates at this level for a year, before slowly lifting them as the housing bubble expanded, without government and Federal Reserve officials ever conceding that a bubble existed.
The question of bubbles and Federal Reserve monetary policy has been an issue for several decades now. In the 1990s when investors fell in love with technology stocks seeing the companies as the key to the “new” world economic order, people began to question whether an investing bubble was developing.
The most famous event during that period, which signaled that at least some people were beginning to recognize the dot.com bubble, was Federal Reserve Chairman Alan Greenspan’s famous “irrational exuberance” speech in December 1996. In that speech, Chairman Greenspan stated: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.” It took three additional years of a rising stock market before the dot.com bubble burst and the first recession of the 21st Century commenced.
Later, as the housing bubble grew, former Federal Reserve Board member Ben Bernanke, then Chairman of the President’s Council of Economic Advisors, testified in 2005 that “house prices are unlikely to continue rising at current rates.” But he added, “A moderate cooling in the housing market, should one occur, would not be inconsistent with the economy continuing to grow at or near its potential next year.” Mr. Bernanke’s view was consistent with that of Chairman Greenspan who was telling the world that he saw no bubble in home prices, but rather “froth” in some local markets. He also cautioned that house prices might fall in some areas and that some borrowers and lenders might suffer “significant losses” if cooling house prices made it difficult to repay the new, riskier types of home loans such as interest-only adjustable-rate mortgages.
Mr. Bernanke’s testimony came only days before he was nominated by President George W. Bush to succeed Mr. Greenspan as chairman of the Federal Reserve Board. So while the Federal Reserve was slow to raise rates to tame the growing housing bubble since it failed to see it forming, it was quick to lend its muscle in stopping the carnage from the financial crisis and to provide as much economic stimulus as possible to help drive a recovery in the U.S. and world economies. According to an article in the Washington Post about Mr. Bernanke, following the announcement of his appointment to lead the Fed, “He [Greenspan] and Bernanke have both said it is unrealistic to expect the Fed to identify a bubble in stock or real estate prices as it is inflating, or to be able to pop it without hurting the economy. Instead, the Fed should stand ready to mop up the economic aftermath of a bubble.”
After the stock market appreciated by 126% between 2009 and 2015, it fell by 10% at one point this year and currently sits 2.5% below the February 2015 peak. Much of the price action this year has been attributed to the anticipation by investors that the Federal Reserve will raise interest rates for the first time since 2008. Investors are worried about the impact of this rate rise on a multitude of factors that impact the fortunes of various economic sectors, the value of the U.S. dollar and what it all means for corporate earnings and capital spending decisions. Given the stock market volatility this year due to the unclear view of what may happen once interest rates begin to rise, we were surprised by Mr. Kaplan’s comments.
Mr. Kaplan seems to ignore the fact that after technology, the key driving force for domestic oil and gas output growth over the past decade has been the availability of cheap capital. It was partially responsible for the recent era of $100 a barrel oil, which provided expectations for outsized financial returns by exploration and production (E&P) companies. In a world where savers and investors have been deprived of appropriate returns for their conservative savings, people have been forced to extend themselves along the risk curve in search of more traditional investment returns. One of the easy ways the energy business found to fund its need for substantial sums of capital required upfront to develop shale resources was to tap the high yield debt market, referred to as “junk bonds.” These bonds are traditionally issued by lower quality (weaker balance sheet) borrowers and as a result can carry hefty interest rates. Those high yields were the primary attraction for investors in the current low-yield environment. Of course, many of these junk bond investors failed to understand the outsized-risk that came along with their reach for those higher returns. They are now paying the price.
According to law firm Haynes and Boone LLP, so far this year 37 North American E&P companies have filed for Chapter 11 bankruptcy, but it fully anticipates additional bankruptcies by yearend. The firm commented that these bankruptcies have dealt with $13.1 billion of debt. The most significant bankruptcy so far this year is Samson Resources Corp., the 2011 $7.2 billion buyout by a group of private equity firms headed by KKR (KKR-NYSE) that saddled the company with $4.3 billion in debt. Falling oil and gas prices, lack of significant production growth and high-priced debt forced the company into a pre-packaged bankruptcy arrangement that saw some of the company’s debt holders receive only about 30 cents on the dollar of debt. That buyout eliminated roughly $950 million in debt and facilitated the addition of $1 billion of second-lien debt to the company’s balance sheet. The key is that this new debt is secured while the debt it replaced was unsecured.
Further highlighting the agony in the industry is the recent $5.4 billion write-down of producing assets and continued bleeding of cash during the third quarter at Chesapeake Energy Corp. (CHK-NYSE). Its high yield bond prices collapsed (see Exhibit 2, next page) when the company signaled further asset write-downs are coming along with the likelihood that it will borrow an additional $2 billion in second-lien debt that will outrank the $11+ billion of bonds that are unsecured debt, sharply reducing their value.
A recent report from investment firm Goldman Sachs (GS-NYSE), which exerts substantial influence in the global commodities market due to its significant trading business, suggested that commodity prices, including crude oil, needed to decline further before corrective market forces will restore an appropriate supply/demand balance. The report was the subject of an article in the Financial Times. The newspaper quoted the following from the report’s conclusion: “Supply adjustments to date are still insufficient, and demand has done too little to offset this slow adjustment. This sustains the need for lower prices for even longer, keeping us underweight commodities for the next 12 months.”
So what role do interest rates play in the energy market? Besides the impact on consumer budgets from higher interest rates, possibly cutting into their discretionary spending including for new homes, automobiles and travel, there remains the question of what higher interest rates mean for the value of the U.S. dollar. As we wrote in the last Musings, the conventional wisdom says that higher U.S. interest rates will drive the value of the dollar up. Foreign money wishing to receive the higher interest rates here needs to sell its local currency in order to buy U.S. dollars, thus driving up the dollar’s value relative to the foreign currency. A stronger dollar will make oil more expensive for foreign buyers as oil is priced in U.S. dollars globally.
On the other hand, we showed in our article that there is a growing body of research demonstrating that during the first 180 days following an initial interest rate hike, the value of the U.S. dollar declines, at least based on the record of the past five rate hikes.
Another look at the impact of rate hikes offers another counterintuitive message for commodities such as crude oil, which is positive stock performance. A report we examined showed that there have been three times when interest rates were raised by the Federal Reserve over multiple quarters, which is what is envisioned for the anticipated upcoming interest rate environment. In each case, the stock market, as reflected by the Standard & Poor’s 500 Index, rose.
While not all market conditions are the same, the stock market performance pattern reflected in Exhibit 4 is somewhat surprising. But what may be more surprising is the examination of the performance of sectors during these periods (shown in Exhibit 5, next page). Energy topped the sector performance list. One has to assume that Energy’s performance was driven largely by the belief that the Federal Reserve’s interest rate hike reflected concern about higher inflation, which is traditionally good for commodities.
One should be careful assessing the 2004-2006 performance of Energy as it was partially fueled by the China/Asian energy boom. Regardless, there was positive Energy sector performance during that period. Interestingly, when looking at the data in the chart, only three of the ten market sectors showed positive performance in all three periods – Energy, Industrials and Healthcare, assuming zero performance is considered positive.
It may be that Mr. Kaplan’s view of the issues confronting energy company CEOs at the present time may be too shortsighted. Maybe those CEOs should be worried about the Federal Reserves’ monetary policy as it has potentially a significant impact on broader forces that may shape their company’s future business environment. As Porter Trimble, president of private E&P company Fleur de Lis Energy LLC put it after commenting about how quickly the energy business can change, “You can’t imagine how quickly core assets become non-core when you’re going broke.”