Could the rising levels of debt in the oil industry contribute to destabilization in the financial system?

The collapse in oil prices has forced drillers to turn to debt markets to keep their operations going. According to the Wall Street Journal, there has been $86.8 billion in new debt issued so far in 2015, a 10 percent increase over last year.

But that trend is not necessarily new. The oil industry has relied on debt for quite some time, but the dramatic fall in oil prices has put a bright spotlight on the practice. The Bank for International Settlements concluded in a March 2015 report that outstanding debt in the oil and gas sector has reached $2.5 trillion, a massive increase over the $1 trillion in debt in 2006. All of that debt could put extra pressure on companies to continue to produce flat out, as cash flows are critical to meet debt payments. Ironically, however, the incentive to continue to produce as much as possible could merely exacerbate the period of depressed oil prices. Related: We Are Witnessing A Fundamental Change In The Oil Sector

That could prevent oil markets from stabilizing. “[I]f the need to service debt delays a pullback in production, a lower price may act more slowly to balance supply and demand,” BIS concludes.

What is interesting is the willingness on behalf of Big Finance to lay out the cash for strapped companies. BIS finds that loose monetary policy since 2008 has contributed to the debt-fueled investment boom in oil and gas. Debt issuance in the oil and gas sector has increased by 15 percent per year since 2006, rising much faster than other sectors. Related: Oil Field Services To Bear The Brunt Of Price Collapse

In the United States, much of the borrowing was done by smaller firms rather than the majors. Some drillers were even cash flow negative, but still heavily tapping the bond market.

Now with oil prices low, banks are cutting their credit lines to the most distressed firms. That could contribute to liquidity problems for drillers that need cash. But it is also indicative of the fact that banks are trying to cut down on the risk to their portfolios. Having heavily lent to oil drillers, some banks are exposed if drillers start to default on debt payments. Related: Can Shell Afford To Drill In The Arctic?

BIS finds that if a broader sell off in oil debt starts to take place, it would bleed over into broader corporate bond markets. And since oil debt makes up a big slice of corporate debt, there are fears (the extent to which is up for debate) that the oil price collapse could have “system-wide” effects. While that could affect the macro economy of entire countries and indeed the global financial system, BIS says that its conclusions are tentative and need more research.

By Charles Kennedy of Oilprice.com

More Top Reads From Oilprice.com: