“We remain more concerned about the future trajectory in oil than any other macro risk at this point in time, including the Fed, rates, flows and market liquidity,” declared Oleg Melentyev, strategist at Deutsche Bank in New York, in late November.
It is not hard to see why. By December 9, the price of oil had dropped 41% since July 23 – down by more than $44 a barrel to $67.
The wider implications of this on the global economy have been the subject of furious debate for months, but in the US high-yield bond market the reaction has been swift and savage: by December 5, total returns in the oil equipment and servicing sector were down by 15.9% and the energy exploration and production (E&P) sector by 15.3% since August 31.
By late November, double-B rated energy bonds were trading 50 basis points wide of the rest of the double-B bond market, single-B energy bonds were 250bp wider and triple-C energy bonds 475bp wider.
|We suspect European high-yield managers would rather |
not be long E&P and just buy another blanket
During the past 10 years, the energy sector has grown from accounting for less than 4% of the US high-yield bond market to more than 16%. According to CreditSights, the face value of debt in the US high-yield E&P and supplier/servicer sectors has tripled since 2008 and now stands at $143 billion face value in the US high-yield index.
The performance of these bonds in the fourth quarter of 2014 reflects huge concern over the potential distress that a sustained price slump could cause.
Melentyev at Deutsche Bank states that a price fall to $60 West Texas Intermediate, if sustained for a considerable period of time, could be sufficient to “push the overall energy sector into distress”. That does not look like such a far-fetched prospect.
Grim out there
It is pretty grim out there already. “A $40-plus price-per-barrel plunge in an emerging sector such as shale that is already bleeding from high ongoing capex is simply as bad as it sounds,” muses Glenn Reynolds, CEO at CreditSights.
The US high-yield energy sector reflects this. “We have seen something approaching carnage in some sections of the high-yield market,” observes Ewen Cameron Watt, global chief investment strategist at BlackRock.
“Even at current prices, the top 50 E&P companies in the US are losing $45 billion cash flow a year and for every $5 to $10 the price per barrel falls distress mounts.”
Cameron Watt points out there is not an impending maturity wall of energy high-yield bonds and that these bonds do not generally mature until 2017 to 2019, so the immediate impact of the price movement will be felt more keenly in the loan market – but many caution against a rush to judgement.
“It is too early to say what the impact of the drop in the oil price will be on high yield,” reckons Kristian Orssten, head of high-yield and loan capital markets at JPMorgan in London. “We would need to see sustained low oil prices for a period of time before the impact becomes clear.
“This will clearly impact, for example, levered companies associated with the oil industry and companies that have hedged themselves forward. Low oil prices should, however, be good for most economies as a whole.”
|Commodities: special focus|
The billion-dollar question is at what point the negative repercussions on the energy sector outweigh the more general benefit to the broader economy of cheaper oil.
“The fall in the oil price presents a huge transfer of wealth to the consumer,” says BlackRock’s Cameron Watt.
This is particularly true in the US, where the reaction is characterized as people getting into their SUVs, driving to Walmart and buying something. Indeed, Federal Reserve Bank of New York chairman William Dudley has claimed that lower energy costs will lead to a substantial rise in real income growth for households and should be a strong spur to consumer spending.
However, the reaction in Europe, and more particularly from the European Central Bank (ECB), has been much more cautious, given the pressing concern over deflation.
“In Europe, the fall in the oil price is seen as deflationary and may move the ECB closer to quantitative easing,” points out Scott Thiel, deputy CIO of fundamental fixed income at BlackRock.
“However, the fall in energy prices can be very short term, so it is not clear that it will be deflationary. The ECB is reacting to short-term oil prices. I find it unbelievable that Bill Dudley and Mario Draghi can have such different opinions on the same subject.”
But while the ECB might see developments in the energy sector as bad news, they are benefiting the European high-yield market versus its much larger US counterpart.
“The good news for the European high-yield asset class and portfolio managers is the outperformance of the eurozone high-yield sectors, given the lack of a major regional E&P sector,” says CreditSights’ Reynolds.
“The bad news, of course, is that Putin might shut off your gas supply in the winter since there is no major regional E&P sector. We suspect European high-yield managers would rather not be long E&P and just buy another blanket.”