The Oil Drum

We have been living in inflationary times, for as long as most of us can remember. The money supply keeps expanding and prices increase over time as a result. Central bankers have many tools at their disposal which they can use to tweak the economy – they can raise or lower interest rates, can control reserve requirements for fractional reserve banking and can inject liquidity into the banking system, among other things – and we have become used to thinking that they can prevent the kind of 'economic accidents' that previous episodes of excess have led to in the past. Especially in recent years – since the apparently successful containment of the dot com aftermath - we have acted as if risk were a thing of the past. Sliced, diced and spread around Wall Street and the rest of the global financial system, risk has seemed tamed, contained and controlled, until last week that is.

For years, industry insiders and so-called experts have proclaimed the virtues of slicing, dicing, and repackaging risk. They waxed on about how borrowers and savers, and society as a whole, could only benefit from such machinations. They suggested any sort of exposure could be disbursed and dissipated to the point where it essentially disappeared. Some even claimed that the crises of the past would no longer exist.

Yet amid the hype and assurances, few supporters spoke of the dark side of wanton and widespread risk-shifting. They didn’t seem — or want — to acknowledge that by combining complicated risks in unfamiliar and unnatural ways, the end result could be an uncontrollable monstrosity—one that eventually turned on its masters.
Nor did they heed the notion that by scattering risk into every nook and cranny of the global financial system, the vast web of overlapping linkages virtually guaranteed that serious problems in one sector, market, or country would trigger far-reaching shockwaves.

All of a sudden, markets are reeling around the world, deals are unraveling, the mainstream press is talking about a credit crunch and the world’s central bankers are injecting unprecedented amounts of liquidity to calm the markets. Risk has made a comeback, and in that environment the evident concern of the central bankers does not seem very reassuring.

Subprime coming home to roost?

A rash of bankruptcies at subprime lenders prompted a market wobble in February and March but traders swiftly decided the problem was contained. Equity markets across the world continued to rally, while the credit market remained phenomenally high in historical terms, thanks in large part to the growth of credit derivatives. These prompted optimism that it had become easier to spread risk and so it was justifiable that even the riskiest companies could obtain credit cheaply.

That mood of optimism is over. Fear now rules the credit markets, where the effective cost of ensuring against a default, in both Europe and the US, has increased by more than half in barely a month. A steady drip of bad news has prompted fears that the subprime debacle could trigger a credit crunch, raising the cost of financing worldwide as investors are forced to sell healthy investments to make good their losses....

....Rather than an orderly correction, they confront a situation where the market for riskier forms of credit seems to have come to a complete halt. US issuance of high-yield, or low-quality, debt stayed below $1bn for the third successive week, according to Thomson Financial. The last week of June brought $9.7bn of high-yield issuance; by last week that had fallen to $322m. This financing is crucial for private equity deals.

"The cancellation of high-yield deals and the inability of the large banks to syndicate their leveraged loans is causing the credit markets to shut down," says T. J. Marta, strategist at RBC Capital Markets. "Something has to give here: either equities have to give it up or credit is going to implode".

As oil threatens to go through the roof over concerns that OPEC may not open the spigots, exploiting Canadian reserves is becoming far more expensive. The threat of labour disruption in the oil sands will only add to the problem.

An OPEC equivalent controlling future LNG trade is seen as a threat to US security, even as natural gas prices decline and the drilling sector consolidates in Canada.

Burnaby BC comes to terms with a long clean up after an oil spill, as the aftermath of a Japanese earthquake rattles the nuclear industry, and Ontario's nuclear troubles continue.

Risk aversion goes international as credit markets tighten around the world. Faced with threatened deals, banks are holding on to loans rather than hawking them to investors. The US sends another more senior figure to China to convince them to buy mortgage-backed securities. As bridge loans become pier loans in the developing credit crunch, Wall Street 'heads for the diaper aisle'.

Oil firms find reserves elusive

For investors looking for the cheapest reserve replacement costs, don't turn to Canada. Not only is the country's oil and gas basin particularly well-developed, making new reserves hard to find, but also Alberta's oil sands boom has driven up service costs above and beyond the increase seen globally. Canada's senior producers' reserve replacement costs went up 40 per cent from 2005 to 2006, while the country's energy trusts and juniors saw costs increase year over year by 62 per cent and 37 per cent, respectively, according to the report.

"The unrelenting rise in reserve replacement costs, coupled with cost pressures elsewhere, has significantly eroded the profitability of crude oil and natural gas developments, especially in high-cost regions such as Western Canada," Mr. Ollenberger said.