A New (Energy) Problem Awaits in Germany

I am writing this from the US Airways Lounge at Philadelphia International airport.

This afternoon, I am flying to Frankfurt, Germany. I have a meeting there tomorrow before I jet off to Warsaw, Poland. I will see the grandkids outside Frankfurt for dinner on Thanksgiving evening, but by that time Marina will have completely become their number one favorite Oma.

After all, that’s nature’s way. It’s best to settle accounts with your children by spoiling theirs.

The family time will be welcome. But we scheduled this trip around some substantive oil and gas conversations. There are two things awaiting me in Europe, and both of them are likely to change the energy landscape.

First up are the consultations in Frankfurt – one tomorrow afternoon and another Friday morning. Both deal with the trajectory of crude oil prices, but both have very different participants.

Tomorrow’s meeting involves bankers. Friday brings in the corporate folks.

While they both need to get their hands around pricing volatility, each has a different underlying interest. European banks in the current environment now have less leverage to establish investment packages for oil deals, thanks to the ongoing credit constriction.

That has changed the approach of oil companies seeking capital. These days, everyone is affected, even the “big boys” I’ll meet with at the end of the week. It used to be in the “old days” – two years ago, some things change rapidly in the international oil patch – companies would simply collateralize their reserves.

It would happen this way: the company would conservatively value the oil still in the ground, coming up with a figure well below what the field geologists know is extractable. A point bank (usually the major “book runner” for finance) would then lowball the expected market value of that already low-volume estimate.

The bank would then syndicate loan risk to a number of other financial institutions, and both sides would make money. The company securing finance would come in with production levels higher than the estimate used in the loan papers and the syndicated network of banks would realize sales at a higher price than the artificially low number used in crunching the initial loan figures.

For Frankfurt, there was another plus from the now discouraged syndication route.

Much of that oil financing business would take place there with Deutsche Bank being the world’s leader in designing syndicated loans for field projects.

My, how time has changed. And it’s having a serious impact on the market.

Now crucial to all of this was an ability to transfer much of the fiduciary risk on to other continental banks. Book runners can also exact a sort of premium when they do this, essentially pushing more of the risk to other houses while retaining a greater percentage of the banking profit.

Today, the problems in interbank credit besieging the European Union have made the syndicated approach far more difficult. Deals are still getting done, but they are far fewer than before the tribulations of Athens, Madrid, Rome, and Lisbon grabbed the headlines.

What has been lost is a fair market value for the loan.

By collateralizing crude oil, the transaction at least remained based upon a “store of value” known to the market as a whole. Oil, after all, remains oil. Its price is a matter widely used. Using crude as collateral, therefore, could avoid most of the moral hazard problem in transactions where one party has a firmer position than another (usually due to the monopoly of information required by their counter parties).

The moral hazard could still be present.

Companies could falsify field data or withhold vital analysis. And so banks would tend to conduct syndications primarily with companies they have had successful experience in the past.

That would still not eliminate the asymmetrical nature of the information relationship, but it would at least put the risk factor in manageable perspective.

Not anymore.

The companies may not have changed, and the fields may look the same, but the participating parties on the banking side are in a very different situation. Little cross-border syndication banking can still be done because the relative strength of essential risk parties is questionable.

Instead, the reality faced by banks in determining risk — and the difficulties confronting operating companies that must now estimate proper production levels — in a volatile pricing environment has changed dramatically.

What ensued has given rise to two very different approaches, each dictated by the current situation. And both have posed some very unwelcome results.

(This is all the reason why I get to spend Thanksgiving with the grandkids sandwiched between meetings.)

The first approach is a banking initiative to collateralize not oil but credit defaults. The second is even more dangerous. Responding to a need that financing structures be developed, entirely new generations of derivatives have been developed.

Both of these put the banks back in the center of the funding equation. However, unlike the previous syndicated version, the actual market value of the collateral is unknown unless it can somehow be tied back to the oil comprising the reason for the finance.

In the first case of using credit defaults, not a particularly unsuspected medium given the state of European banking, another step is required. Otherwise, the only object accomplished would be releasing some funding via a deep discount of the defaults.

That other step is the utilization of such a discounted value of defaults as leveraged collateral to back crude oil futures contracts. Some readers may recall I first discussed this last year when I was advising the Greek Finance Ministry. Then, it was discounted Greek debt held by other European banks that was beginning to show up in such an exchange. Now it is far more widespread in application (as a great deal more such debt emerges in wider banking circles).

The second approach is even more troubling.

Just as subprime mortgages were bundled and used as collateral to create entire arrays of derivative paper, so also is the practice now spreading into oil finance. Once again, this is tied to futures contracts. But it is resulting in two very disturbing results.

One is the rising inability of paper barrels (futures contracts) and wet barrels (the actual consignments of delivered oil) to converge when the paper expires. Traditionally, that would be solved by arbitraging on one end of the transaction at expiration of the paper. Now, an expanding range of intermediary transactions are required to make square pegs fit with round holes.

The other disturbing result is obliging companies to play this game with their own production, in effect expanding or suppressing extraction rates not because of market factors, but due to what the derivatives require.

This is not simply artificial. It can develop into a fundamental and protracted distortion of the entire process in the name of securing finance.

Both the usage of credit defaults and the rise in exotic derivatives alter futures contract pricing determinations and the all-important ability to peg implied volatility for options on those contracts (think of this as setting a proper “premium price” for an insurance policy needed to manage risk). They also do something else.

We are no longer able to provide a genuine market value for either collateral. This is no longer oil in the ground. Finance has become based upon paper having little if any independent value at all.

This will begin undermining the trading system itself.

When a genuine spike up or move down in genuine wet barrels prices emerges, the hall of smoke and mirrors being created to keep oil finance going in an age of constricted banking will act like a turbo charge. It will accentuate the volatility, destroy value, and bury the real exchange value of oil beneath a mountain of suspect intermediary paper.

Meetings like the ones about to happen in Frankfurt are the front lines in combating a far more serious undermining of oil market dynamics.

But the horse may have already left the stables.

In contrast, my upcoming meeting in Warsaw, Poland session has a very different target and prospects. This is not just for Poland, but also for the broader European energy balance.

I will address that in the next OEI.

Have a wonderful Thanksgiving.