2 Ways Crashing Oil Prices Could Trigger the Next Global Financial Panic

The recent crash in oil prices, the worst since the financial crisis, has left investors in oil-related stocks reeling, but U.S. consumers are cheering as gas prices have plunged nearly 40% to their lowest levels in five and a half years. 

WTI Crude Oil Spot Price data by YCharts.

U.S. Retail Gas Price data by YCharts.

This has led some economists and analysts to speculate that declining energy costs will serve as a strong global economic stimulus. In fact, Citigroup estimates that low oil prices will contribute over $1.1 trillion in extra spending money to global consumers in 2015. 

However, while most people are cheering oil's fall as they drive past the pump, some analysts are also warning that the severity and speed of oil's fall increases the risk of another financial panic, one on a potentially global scale. Here are the two biggest risk factors that could bring about such a worst-case scenario.

U.S. energy junk bond market implodes
Since 2010, U.S. energy companies have borrowed $550 billion to invest in America's booming shale oil and gas industry. A good deal of this borrowing was through high-yielding junk bonds, which now comprise $210 billion, or 16% of America's $1.3 trillion junk bond market.

Plunging oil prices have resulted in yields on some of these bonds soaring as investors fear that many debt-laden oil and gas producers will be forced to default.

Sources: Morningstar.com, Yahoo! Finance, Bloomberg.

As this table shows, companies like Energy XXI and Linn Energy have debt/EBITDA ratios 3.2 to 14.2 times higher than their industry average, while Midstates Petroleum and Magnum Hunter Resources' ratios are negative because they don't even generate positive EBITDA. Thus it's not surprising that some of these bonds are now trading for as little as $0.33 on the dollar.

Just how bad could things get in the U.S. junk bond market? Well that depends on how long oil prices remain depressed. According to a report by JPMorgan, three years of oil at $65 per barrel would likely result in a 25% to 40% default rate across the energy junk bond market. 

While JPMorgan doesn't believe oil will remain that low for that long, some experts do. In fact Andy Xie, former head economist for Morgan Stanley and the IMF, believes that "$60 will be the normal price for the next five years or so."

If oil bears like Mr. Xie are proven correct, then the rate of default on U.S. energy junk bonds could soar above even JPMorgan's worst-case scenario, and institutions such as banks and pension funds, who've been eagerly buying these high-yield investments, might face steep losses, which could potentially snowball into a domino-like chain of inter-bank loan crises.

In addition, a high rate of junk bond defaults could restrict future access to smaller U.S. energy companies and hinder America's shale oil boom even if oil prices do recover.

Russian corporate bonds pose a potentially global threat
Another major risk factor for a potential financial crisis lies in Russia, where total corporate debt totals $660 billion, according to Wells Fargo analysts -- $160 billion of which is denominated in foreign currency and held by foreign companies, mostly in Western Europe.

Of this debt, between $90 billion and $117 billion will need to be repaid in 2015. With Western sanctions shutting off access to foreign credit markets, and Russia's economy likely headed for a steep recession in 2015, the specter of a wave of corporate defaults triggering a financial crisis in an already-fragile European debt market has some analysts concerned.

Thus far, Moscow has been willing to help some of its more strategic companies avoid default by lending them U.S. dollars from its foreign currency reserves. However, given that Russia's foreign currency reserves have declined by $150 billion--28.6%--in just the last 11 months, and with Moscow spending $80 billion over the just the past year fighting a losing battle to stop the Ruble from crashing, there is a limit to how much Putin's government can bail out Russia's corporate debt.

If Russian corporate defaults do end up triggering a broader financial crisis in Europe, then the already-sputtering European economy could be thrust into recession, further decreasing global oil demand. This in turn might cause oil prices to crash further, and only worsen Russia's economic situation in a viscous spiral of mounting global inter-corporate and inter-bank debt defaults.

How likely are these scenarios? 
How likely are U.S. energy companies to default on their junk bonds? While plunging oil prices mean that some will, many companies may be able to stave off outright default. For example Energy XXI's Vice President Greg Smith recently told Bloomberg, "come January we'll be free cash flow positive," which is "a rarity in this business." If the company slashes spending on new drilling, as its competitors are doing, then it may be able to pull through without defaulting assuming oil prices recover later in 2015. 

Similarly, Linn Energy just made the hard but necessary choice to slash its distribution and capital spending budget by 56% and 53% respectively. In addition, the new deal with GSO Capital Partners, an affiliate of The Blackstone Group L.P (NYSE: BX) should keep Linn Energy from defaulting as well. This deal, along with the series of deals and acquisitions it's executed over the last year to reduce capital spending costs by $550 million to $650 million per year, should go a long way in helping it serve both the interests of long-term income investors and bond holders. 

Meanwhile Russia's troubles, while potentially much more serious than the U.S. energy junk bond threat, could also find a solution thanks to Russia's longtime strategic energy partner, China. Back in December, Beijing executed a $24 billion currency swap to stabilize the Ruble, which was funded out of China's nearly $3.9 trillion in foreign currency reserves.

While there certainly are limits to China's ability to aid its Russian ally, given Russia's immense energy reserves the potential for an enormous long-term loan, backed by Russian oil and gas assets, might be able to avert a financial meltdown such as Russia's 1998 default which resulted in GDP growth of -5.3%, inflation of 86%, and unemployment of 13%. 

Bottom line: Oil prices falling may be beneficial, but only to a point
Don't get me wrong. I'm not predicting that crashing oil prices will trigger an oilpocolypse that sends the world into another financial meltdown. However, I do want to highlight the fact that today's world is a far more indebted and complex one, where bonds, both government, and corporate, are held through international relationships that makes predicting the effect of such a severe and potentially long-term commodity crash unpredictable. Most likely, the negative effects of plunging crude on the U.S. junk bond market will be contained and perhaps result in no worse repercussions than a credit crunch for smaller energy producers. Similarly, Russian bond troubles will most likely only result in a potentially protracted and painful Russian recession.

I do think investors should be aware of the risks, however small, that oil's recent collapse may lead to something far worse -- an expanding bond-fueled contagion that could lead to another global financial credit crunch.