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$30 Oil Could Spark Contagion In Energy Markets

Oil Well Broken

If oil prices continue to fall, the financial damage could start to become a concern.

A new analysts from Deutsche Bank finds that the high-yield energy market could start to suffer from contagion if oil prices drop to the mid-$30s. At $35 per barrel, for example, the debt-to-enterprise value jumps to over 55 percent for a lot of high-yield energy companies. The result could be a surge in yields that put a lot of pressure on companies. Yields are already up 1 percentage point over the past month, corresponding with the plunge in oil prices. But if prices fall further, yields could rise to more worrying levels.

For now, the recent gains in oil prices from the ten-month lows hit last week could ease concerns. But if oil traders are just taking a breather before another downturn, then there could be trouble ahead for the high-yield market. The pain suffered by sub-investment grade energy companies could bleed over into broader junk bonds. “Oil weakness to this point is problematic directly to energy valuations but is not yet a cause for credit-loss concerns in energy or the broader high-yield market,” Deutsche Bank analysts said in a recent research note. “We are getting closer to the point where this narrative could begin to change.”

The investment bank went on to add: “We would become mindful of implications for the broader high-yield market if oil were to drop under $40, and particularly if it were to head toward $35.”

If yields spike, it will be a lot more difficult for struggling energy companies to access the debt markets. Ultimately, that could put them in a bind. “The high-yield bond market is waking up,” Ryan Kelly of PGIM, the investment management arm of Prudential Financial Inc., told the Wall Street Journal. “There’s been a change in tone.” Related: Saudi Reshuffle Could Completely Shake Up Oil Markets

Other analysts share similar sentiments. UBS says that WTI staying at or below $40 for a year would “elevate 2015-style risks for [high-yield] energy.”

We have seen this story before. In early 2016, when oil prices dropped below $30 per barrel, it started to drag down stock indices around the world. Some are even speculating that the latest downturn in prices is not just a problem for the high-yield market, but perhaps an indicator of a coming economic recession.

Still, the predictions about financial contagion could be overblown. Many of the least-efficient shale companies already went bankrupt over the past several years. The survivors are better suited to survive low oil prices.

Moreover, unlike past oil price downturns, this one is a supply-driven phenomenon. As CNBC notes, the 2008 plunge in prices was a result of the global financial crisis and a meltdown in demand. Other past recessions have also led to a downturn in prices. If global GDP slips, for example, demand will slow, which will push down prices.

But the dips since 2014 are the fallout from a surge in supply. That difference could be why the financial carnage from another crude oil meltdown stays isolated to the energy sector. "This time around it's supply driven, and low oil prices are only a problem for oil companies and one-trick-pony oil-producing countries," John Kilduff of Again Capital told CNBC. "If the oil price slide were an early indicator of a slowing global economy, then stocks would follow suit but that does not appear to be the case." Related: Underperforming Energy Sector May Soon See M&A Wave

In fact, lower oil prices could juice the economy, not only by leading to lower costs for consumers, but also dragging down inflation, which could deter the Fed from further rate hikes. CNBC also notes that the energy sector makes up a smaller share of the S&P today – about 6 percent – than it did back in 2008 when it was 15 percent. A deeper plunge in oil prices would have less of an effect today than it did in the past. “If energy prices are falling, it may be detrimental to energy companies but it's materially beneficial to everyone and everything else," Dennis Gartman, editor of the Gartman Letter, told CNBC.

This debate could be a moot point if oil prices stabilize and rise back to the upper-$40s. But with a growing number of analysts seeing oil heading below $40, we may find out if it starts to drag down other parts of the financial sector.

By Nick Cunningham, Oilprice.com

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