Does the oil crash signal another financial crisis?

Falling oil prices are a problem, but it's not the mortgage industry circa 2008

Is a financial storm building?
(Image credit: Dale Wilson/Masterfile/Corbis)

The crash in oil prices has come to Wall Street.

Like any other business, energy companies operate on a complex dance between revenues, borrowing, and investment. They make money by pumping oil out of the ground and selling it. But before they can do that, they have to hire the workforce, build the oil platform, establish the infrastructure, and do the drilling. That means a lot of up-front costs, financed by investment and borrowing. It's worthwhile because ultimately you can pay off your debt obligations once the oil revenue comes in.

Unless, of course, global oil prices collapse, tanking your revenue. Then companies can't pay their debt obligations, and they may go bankrupt, and a lot of revenue banks expected to get from debt payments evaporates. Banks have to write off loans, start spending reserves to stay afloat, the financial markets freak out, and bank stocks fall.

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Which is exactly what's happening: Bank of America had to set aside an extra $264 million in 2015's fourth quarter to cover losses, and its stock has dropped 15 percent since the start of 2016. Citigroup, Wells Fargo, and JPMorgan Chase have also been hit, and their overall shares have dipped 8 percent. The broader stock market, already rattled by China and hit by several plunges since the new year, dropped again on Wednesday amid renewed panic over oil prices and the global slowdown, before recovering a bit by the close of the day.

It could get worse, though. Plenty of banks have been trying to avoid cutting off oil companies from financial support as long as they can. If a company just sits dormant, it's a lot easier to restart the real-world economic activity that company engaged in than if it goes bankrupt entirely. But the oil price plunge happened over a year ago now, so banks are running out of room. On top of that, oil companies hedge in the financial markets like anybody else to protect against these sorts of price drops. But plenty of those hedges — and the revenue to the oil companies they provide — are scheduled to expire early this year.

In a rough way, the oil price plunge resembles the 2008 financial crisis: There was a lot of debt in the system, and suddenly that debt couldn't be paid, leading to a crisis for the financial books of the big banks and other Wall Street firms.

But there are also some key differences that are worth drawing out.

The first one is just a matter of scale. As The New York Times reported, "Loans to oil and gas companies make up less than 2 percent of the loans at Bank of America and Wells Fargo — a far cry from the residential mortgage exposure at some large banks, which was as high as 25 percent leading up to 2008." The reforms spurred by the financial crisis also helped: The banks have much bigger capital cushions today than in the run-up to 2008, and even if the worst happens, it doesn't look like the oil price plunge could come anywhere close to eating through those cushions.

But there's also a deeper reason why oil debt hasn't infected Wall Street finances the way bad mortgage debt did.

Oil debt is a very straightforward thing. Someone wants to drill for oil, a bank decides how much risk the project involves, then makes a loan accordingly. Then that bet either pans out or it goes bad. But drilling for oil is a pretty concrete thing: You can look at the plan, the geology of the drilling area, and the shape of the market, and make a pretty good guess about what you're getting yourself into. The risk is manageable, which is why it hasn't spread beyond 2 percent of Bank of America and Wells Fargo's loans. The oil plunge has been a surprise, but there's no reason to think the banks catastrophically and systemically misplaced the risk involved.

The 2008 housing crisis, by contrast, was not merely a matter of too much debt, as some commentators have argued. It was a matter of way, way, way too much debt, and it was a matter of catastrophically and systemically misplacing the risk of that debt: Super-complex financial instruments and mortgage packages rendered accurate risk-pricing basically impossible.

Another key difference is the effect on real human beings on the ground. When all those mortgages went bad in 2008, it meant huge stores of wealth that millions of families thought they owned just disappeared. Their finances cratered, and they lost livelihoods, homes, and jobs. At the level of the entire economy, that meant a massive and sudden drop in aggregate demand, plunging us into recession. But the effect of the oil price drop on the aggregate economy is far more ambiguous.

Certainly, it's hard on the energy companies going under and the workers they will lay off. But cheaper gas also means the budgets for millions of consumers and even a few countries will go further. That's an increase in aggregate demand.

The point is complicated by the fact that some countries are deliberately pumping more supply to drive down the price and corner more of the oil market. It's risky strategy, since lower prices hurts all oil producers' pockets. But if it works, you drive your competition out of business.

That's made the price drop deeper and more severe than expected. Which also means its negative effects on the financial markets and the real economy have probably been larger than textbook economics would suggest.

But at this point, the differences between the oil crash and the 2008 crisis matter much more than the similarities.

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Jeff Spross

Jeff Spross was the economics and business correspondent at He was previously a reporter at ThinkProgress.