Financial Contagion Strikes Back

Copyright © 2023 Energy Intelligence Group All rights reserved. Unauthorized access or electronic forwarding, even for internal use, is prohibited.
An xin - Imaginechina/AP Images

Financial contagion once seemed banished. Few bank failures occurred from the end of World War II to 1979. However, there have been at least four since 1980: the Penn Square Bank failure in 1982, the savings and loan meltdown in 1988, the Great Recession caused by Lehman Brothers’ bankruptcy, and now, in 2023, the closure of Silicon Valley Bank (SVB). Contagion has returned with the world’s deregulation of financial markets. Its return seems to be the cost of accelerated economic growth. On the downside, however, substantial damages have been imposed on important economic sectors after every banking crisis. The impacts on the petroleum business have been particularly harsh, and now the fallout for oil following SVB’s failure may be especially severe.

Bank failures follow periods of loose credit and diminished regulation. The bankruptcy of Penn Square, a small, obscure Oklahoma bank, resulted from its free and easy lending practices to the oil industry. Thanks to Penn Square’s support, many new exploration companies were able to expand. Penn Square fell when plummeting oil prices caused these firms to default on their loans. The bank’s collapse had magnified impacts because it had widely syndicated its loans with other institutions. One major bank, Continental Illinois, failed after Penn Square because it had purchased $1 billion in speculative energy-related loans initiated by the Oklahoma bank.

Penn Square’s closure depressed activities in the US independent oil and natural gas exploration sector for over a year. Many blamed falling oil prices. However, the aggressive oversight of federal bank examiners was likely more important. Well-known independent oil and gas company executives commented on their rigid approach. Credit that had been essentially free in early 1982 was no longer available at any price.

Regulatory Swings

We saw the same story after the savings and loan crisis and the 2008 Lehman collapse. The lesson is that good times lull many in the financial community into complacency. Lobbyists lean on politicians and regulators to ease rules. In essence, the latter gets leashed and muzzled. Then, when a crisis crops up, the muzzles and leashes come off, allowing bank examiners free rein. The consequences are ugly. Banks suddenly have to adhere to stringent, constraining lending standards. The petroleum industry is particularly vulnerable to such tightening because it requires huge credit lines to fund operations.

SVB’s failure will be attributed to lax regulations and lending standards. After smaller banks lobbied hard for regulatory relief, former President Donald Trump signed a law in 2018 that hamstrung regulators. Then SVB and probably other banks like it eased up on lending restrictions. On Mar. 13, for example, the New York Times reported that one Silicon Valley investor who banked with SVB praised the bank, noting that he and his family would not be in their home otherwise. SVB approved his mortgage “within a week” after 15 other banks and lenders had rejected his loan application.

Just seven days before the bank’s collapsed, its CEO, Greg Becker, told an audience that it was “a great time to start a company,” adding that exciting prospects existed in all technology categories. Becker, like the Oklahoma wildcatters in 1982, was fixated on continued growth and profits.

Smaller firms in the technology space, including many new companies focused on the energy transition, will suffer from SVB’s failure to operate as a bank. Those in technology complain that larger banks refuse to take their business. These statements overlook the fact that they have feasted at banks that lend freely without collateral. Why would any firm turn to JPMorgan, which requires borrowers to put up 20% or 30% of the cash needed to fund a project, when an SVB would provide all the money? Investment going forward will slow as all banks tighten their lending standards.

Oil Industry Hit

These stricter standards will hit the oil industry quickly. After the SVB failure and the subsequent Credit Suisse stock price drop, banks are rushing to build cash reserves, according to Bloomberg. This implies the banks will have less to lend. The reduced loan activity will affect oil companies, oil traders, and those buying and selling futures contracts. The costs of holding stocks will rise. Inventories will fall, as I wrote on Mar. 3: Prepare for the Great Inventory Liquidation. The reduction in stocks, which may be precipitous following SVB and Credit Suisse woes, will put significant downward pressure on prices.

Additional pressure will come as oil producers rush to hedge production. Shale producers’ senior executives have eschewed hedging over the last year, telling shareholders and the public they wanted to preserve the upside for their investors. Now, some will be required to hedge future production by suddenly conscientious bank lending officers to tap credit lines. This forced hedging will depress prices further.

The price decline will slow exploration and production, just as they did in 1982 with the Penn Square failure. The output decrease, in turn, will allow prices to strengthen, especially if Opec responds with its own production cut.

Longer-Term Outlook

Over the longer term, SVB’s collapse will benefit large energy companies, slow the growth of new entrants, and make entry more difficult for entrepreneurs. Historically, bank failures and liquidity crises have bolstered firms with good balance sheets, sped the demise of financially weak firms, and raised obstacles to new business.

The rapid growth of companies like Apple and Microsoft after the financial market deregulation that began in the 1970s is no accident. Access to money became easier, and growth followed. The entry of new firms becomes far harder in times of tight credit. Thus, the major existing companies in the energy sector, oil included, can look forward to several years of reduced competition from such entrants.

Mark Twain once wrote that history does not repeat but rhymes. The recent history of contagion reads less like a poem and more like a song stuck on replay. History is repeating.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.

Oil Prices, Oil Inventories, Macroeconomics
Wanda Ad #2 (article footer)
The reconciliation between Saudi Arabia and Iran recently brokered by China could radically transform regional and global geopolitics if consummated.
Tue, Mar 21, 2023
The commodity was only just recovering from the latest financial fears when concerns over UBS and Deutsche Bank emerged Friday.
Fri, Mar 24, 2023
Russia's deputy prime minister says the discount for Urals crude oil has narrowed since January and will continue to do so.
Thu, Mar 23, 2023