THE PERFECT STORM 89the alternative energy sector. When I say alternative I mean in
the fracking sector.
A lot of it’s in the Bakken and North Dakota, but also in
Texas and Pennsylvania. That’s a lot of money. It’s been large-
ly financed with corporate and bank debt. These companies
issued some equity, but it’s mostly debt.
Here’s how it works. Suppose I’m an oil exploration com-
pany. Let’s say I borrowed a couple hundred million dollars to
drill for oil using fracking technology. The bank -- the lender,
bond investor or whoever — says: “Well, Jim, you just bor-
rowed $200 million. How are you going to pay me back?”
And I’d say: “Well, I’m going to sell my oil at $80 a barrel.”
To which the bank says: “How do I know that’s true?”
So, I go to Morgan Stanley, JP Morgan or Citibank and
I buy what’s called a “swap contract.” It’s a kind of derivative.
Citibank or whoever basically agrees to pay me the differ-
ence between $80 and the actual price of oil. If oil goes to $50
and I have a swap contract with Citibank that guarantees me
$80, they have to pay me the $30 difference. That way, I’ve
locked in the $80 price.
That’s not a free lunch. Oil producers give away the upside.
If crude prices go to $150 they might have to pay the lenders
the difference. But oil companies try to protect their downside.
Oil companies are protected because when oil goes to $50
because they can call up the bank and say: “Hey, bank, send
me the other $30 a barrel because we have a deal.” And the
bank will have to send it to them.
Through the derivative contract the loss now moves over
to the bank. It’s not the oil company that suffers the loss. This
is the case with the global financial system today — you never
know where the risks end up.
So the first iteration is that some of the oil companies —
not all of them — have shifted their risk over to the banks by
doing these derivative contracts.