Oil price drop spells trouble for bonds: BIS

Is $40 oil on tap?

A toxic mix of high levels of debt in the oil sector and the sharp decline in the price of the commodity could have far-reaching effects on the global economy, economists at the Bank of International Settlements (BIS) warn.

New research from the BIS, known as the central bank of central banks and one of the few organizations to foresee the global financial crisis of 2008, shows that the total debt of the oil and gas sector worldwide stands at roughly $2.5 trillion, two and a half times what it was at the end of 2006.

With oil prices around 60 percent lower than they were in mid-June 2014, the bank said that there had been a significant decline in the value of assets backing the debt in this sector. The authors of the report - BIS economists Dietrich Domanski, Jonathan Kearns, Marco Lombardi and Hyun Song Shin - have found that long-term investors might soon lose their appetite for this debt and compound a sell-off in the wider corporate bond markets.

"Being able to absorb losses in the short term, long-term investors in debt securities have often been considered a stabilizing influence on financial markets. However, recent experience suggests that even long-term investors have limited appetite for losses and may join in any selling spree," the four economists said in the report released on Wednesday morning.

"A sell-off of oil company debt could spill over to corporate bond markets more broadly if investors try to reduce the riskiness of their portfolios. The fact that debt of oil and gas firms represents a substantial portion of future redemptions underlines the potential system-wide relevance of developments in the sector."

A gas flare burns an oil worker monitors a water tank while loading saltwater from an oil well storage tank near Sidney, Montana.
Daniel Acker | Bloomberg | Getty Images

The U.S. has seen a revolution in gas and oil production in the U.S. with new technology unlocking new shale resources. This oil and gas boom has spurred economic activity and given the U.S. oil and gas industry a competitive edge over other exporting countries thanks to less expensive fuel prices. However, the recent drop in prices is hitting the sector as well as larger oil majors and governments which are reliant on the revenues of state-run oil firms.

Bob Dudley, the CEO of BP, told CNBC last week that the dramatic drop in prices and the transfer of wealth to consumption-led industries would be "very painful" for the oil and gas sector. Dennis Gartman, the editor and publisher of the Gartman letter, has warned to CNBC previously of bankruptcies in the U.S shale sector.

The dramatic fall in the price has been due to weak demand, a strong dollar and booming U.S. oil production, according to the International Energy Agency (IEA). The Organization of the Petroleum Exporting Countries' reluctance to cut its output has also been seen as a key reason behind the fall. The group produces about 40 percent of the world's crude oil.

The BIS authors spoke of risk-shedding by the banking sector which had freely given loans to these oil firms and shale explorers. It said that there was anecdotal evidence to suggest that this risk-shedding is similar to other episodes of sharply declining values of collateral assets. The high debt level of the sector also complicates the macroeconomic assessment of lower oil prices, according to the BIS economists.

"Any amplifying effect of high leverage on capital expenditure in the oil sector could have knock-on effects on investment in other sectors," the authors also stated.

"Retrenchment in the oil sector could therefore affect the outlook and spending in energy-related sectors, but also in other sectors of economies or regions that are heavily dependent on oil production."

The economists from the Basel-based institution warned that the impact of the oil price collapse on government revenues could be large. They added that even countries that had hedged their positions could come under pressure is these hedges expire before oil prices recover. Oil firms from emerging market economies could also face significant strains, they added.

"(They) may be perceived to be more risky and find access to new foreign currency borrowing more difficult than those in advanced economies. Given that EME (Emerging market economy) oil firms have increased their borrowing sharply over the past decade, they could be particularly susceptible to tighter credit conditions."