Many economists have said that the recent collapse of oil prices is a good thing.
After all, consumers are paying lower prices at the pump, and this de facto tax cut will presumably encourage spending, thus buoying the economy.
But the truth is much more complicated, and much darker, than the rosy picture being painted.
In reality, oil’s plunge will have painful consequences that’ll be felt across the economy…
First and foremost, there’s potential for defaults in the high-yield bond market, and oil and gas companies are already feeling the pinch.
But oil’s impact on high-yield bonds is already well-documented… and the best investors are able to anticipate outcomes before they make the headlines.
Thus, we need to look at how oil’s plunge will affect other sectors – such as banking, which is the lifeblood of our credit-based economy.
Banks at Risk
The banking system could be on the verge of a nightmarish credit scenario should oil prices remain depressed.
Indeed, if energy companies begin to default, a vicious cycle could ensue.
As energy companies start to face liquidity concerns, banks could rein in lending to energy companies in general – which would cause other struggling companies to default when they can’t access credit.
All told, it’s not hard to imagine a mini credit crisis for shale oil companies in the near future.
Thus, we should avoid firms like those in the chart below, which identifies banks with some of the highest exposure to energy loans:
At this point, investors should be wary of banking ETFs, as well – particularly regional banks that could be exposed to the energy sector, such as the SPDR S&P Regional Banking ETF (KRE), which includes all three of the above banks in its holdings.
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Meanwhile, direct exposure to energy loans isn’t the only concern for these mid-cap banks.
You see, banks thrive when the yield curve is steep… but the curve has been flattening lately, because investors are skeptical about robust economic growth. That could be a bad sign for the broader economy and could portend trouble across the entire banking industry.
Shadow Banks at Risk
Business development companies (BDCs) are essentially “shadow banks” that lend to companies that may be too small to obtain financing from traditional banks.
Many BDCs are also exposed to oil and gas companies and are facing a dire situation. Check out the table below to see a few BDCs that are highly exposed to the energy sector:
Though these firms have extremely tempting yields (four out of five sport a yield above 9%), these high yields can indicate unacceptable risk, as we’ve seen with Seadrill and Canadian Oil Sands already.
The Final Word
As you can see, the potential fallout from oil’s collapse could be very painful – even if consumers are happy to have inexpensive gasoline back at the pumps.
In fact, the effects of oil’s price plunge could be catastrophic for the entire economy. On top of everything else, capital expenditure budgets are being cut in key areas of the country.
Texas and North Dakota, for example, have been bright spots in the recovering economy… but this latest setback calls that growth into question and presents new challenges for the energy sector.
For now, avoid lenders that are exposed to energy companies. In the meantime, we’ll keep you one step ahead of the news cycle – and the market.