The Connection Between Financial Markets and Energy

[phantom power]

Apropos of nothing, the author has one of my favorite internet handles: Gail The Actuary.

Some may be asking how all of this is tied to oil and energy. There are quite a number of relationships:

(1) Some of the organizations with problems were no doubt speculating in oil futures. Once the prices started to drop, the balance sheets of the organizations were affected, and they suddenly needed more capital.

(2) As the companies who speculated in the oil market (all of them, not just the particular ones having problems today) try to unwind their positions because of margin calls, they drive down the price of oil in the futures market. That is likely why we are seeing declining oil prices, at a time when fundamentals would say they should be rising.

(3) As the price of oil and food rises, people have less money to pay debt of all kinds. This has contributed to the rising mortgages defaults, and is helping to drive down home prices. This is very closely tied to problems of banks and other financial institutions.

(4) Structured securities based on sliced and diced mortgages and other debt depend on assumptions regarding "independence of defaults". Once a shortage of oil and higher food and energy prices start causing mortgage defaults, the defaults are no longer independent (as they would be if they were caused by an illness of a particular homeowner, for example). Instead, there is a systematic bias in the pricing the risk, and the structuring doesn't work as planned.

(5) Energy companies need well-functioning credit markets to expand their exploration and production, and to pursue alternative energy approaches. For example, expanding the use of wind energy, or electric-powered vehicles, is likely to need a huge amount of debt financing.

I have warned in the past about the possibility of a debt implosion. There is a significant possibility that what we are seeing now is beginning of such an implosion. There are a number of institutions that have problems. Systemic risk (caused in part by counter-party failures) can cause these problems to spread to other institutions.

http://www.theoildrum.com/node/4534