Plummeting Oil Prices Could Destroy The Banks That Are Holding Trillions In Commodity Derivatives

By Michael Snyder

Could rapidly falling oil prices trigger a nightmare scenario for the commodity derivatives market?  The big Wall Street banks did not expect plunging home prices to cause a mortgage-backed securities implosion back in 2008, and their models did not anticipate a decline in the price of oil by more than 40 dollars in less than six months this time either.  If the price of oil stays at this level or goes down even more, someone out there is going to have to absorb some absolutely massive losses.  In some cases, the losses will be absorbed by oil producers, but many of the big players in the industry have already locked in high prices for their oil next year through derivatives contracts.  The companies enter into these derivatives contracts for a couple of reasons.  Number one, many lenders do not want to give them any money unless they can show that they have locked in a price for their oil that is higher than the cost of production.  Secondly, derivatives contracts protect the profits of oil producers from dramatic swings in the marketplace.  These dramatic swings rarely happen, but when they do they can be absolutely crippling.  So the oil companies that have locked in high prices for their oil in 2015 and 2016 are feeling pretty good right about now.  But who is on the other end of those contracts?  In many cases, it is the big Wall Street banks, and if the price of oil does not rebound substantially they could be facing absolutely colossal losses.

It has been estimated that the six largest “too big to fail” banks control $3.9 trillion in commodity derivatives contracts.  And a very large chunk of that amount is made up of oil derivatives.

By the middle of next year, we could be facing a situation where many of these oil producers have locked in a price of 90 or 100 dollars a barrel on their oil but the price has fallen to about 50 dollars a barrel.

In such a case, the losses for those on the wrong end of the derivatives contracts would be astronomical.

At this point, some of the biggest players in the shale oil industry have already locked in high prices for most of their oil for the coming year.  The following is an excerpt from a recent article by Ambrose Evans-Pritchard…

So they are protected to a very large degree.  It is those that are on the losing end of those contracts that are going to get burned.

Of course not all shale oil producers protected themselves.  Those that didn’t are in danger of going under.

For example, Continental Resources cashed out approximately 4 billion dollars in hedges about a month ago in a gamble that oil prices would go back up.  Instead, they just kept falling, so now this company is likely headed for some rough financial times…

Oops.

When things are nice and stable, the derivatives marketplace works quite well most of the time.

But when there is a “black swan event” such as a dramatic swing in the price of oil, it can create really big winners and really big losers.

And no matter how complicated these derivatives become, and no matter how many times you transfer risk, you can never make these bets truly safe.  The following is from a recent article by Charles Hugh Smith…

In recent years, Wall Street has been transformed into the largest casino in the history of the world.

Most of the time the big banks are very careful to make sure that they come out on top, but this time their house of cards may come toppling down on top of them.

If you think that this is good news, you should keep in mind that if they collapse it virtually guarantees a full-blown economic meltdown.  The following is an extended excerpt from one of my previous articles…

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For those looking forward to the day when these mammoth banks will collapse, you need to keep in mind that when they do go down the entire system is going to utterly fall apart.

At this point our economic system is so completely dependent on these banks that there is no way that it can function without them.

It is like a patient with an extremely advanced case of cancer.

Doctors can try to kill the cancer, but it is almost inevitable that the patient will die in the process.

The same thing could be said about our relationship with the “too big to fail” banks.  If they fail, so do the rest of us.

We were told that something would be done about the “too big to fail” problem after the last crisis, but it never happened.

In fact, as I have written about previously, the “too big to fail” banks have collectively gotten 37 percent larger since the last recession.

At this point, the five largest banks in the country account for 42 percent of all loans in the United States, and the six largest banks control 67 percent of all banking assets.

If those banks were to disappear tomorrow, we would not have much of an economy left.

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Our entire economy is based on the flow of credit.  And all of that debt comes from the banks.  That is why it has been so dangerous for us to become so deeply dependent on them.  Without their loans, the entire country could soon resemble White Flint Mall near Washington D.C….

I keep on saying it, and I will keep on saying it until it happens.  We are heading for a derivatives crisis unlike anything that we have ever seen.  It is going to make the financial meltdown of 2008 look like a walk in the park.

Our politicians promised that they would do something about the “too big to fail” banks and the out of control gambling on Wall Street, but they didn’t.

Now a day of reckoning is rapidly approaching, and it is going to horrify the entire planet.

This article was originally published on The Economic Collapse and is republished under the provisions of the U.S. Copyright Law doctrine of “fair use” in an effort to advance a better understanding of political, economic, and social issues.  

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