Back in May, we pointed out an interesting observation made by Goldman: unlike late 2015 and most of 2016, when equities demonstrated surprising resilience to the swoon in oil prices, in 2017, OPEC's failure to stabilize oil prices finally hit energy equities disproportionately. As Goldman said in mid-May, discussing the latest crude oil selloff, which has been "even more pronounced for longer-dated contracts reflecting increasing concerns over future balances in 2018 and beyond"... "in the HY market, the Energy sector has again outperformed its beta to crude over the past few weeks, a pattern that is reminiscent of previous oil sell-off episodes in the second half of 2016 and early 2017 (Exhibit 3)." Goldman also pointed out that the outperformance among energy high yield bonds "also contrasts with the sharp underperformance of Energy equities since the beginning of the year (Exhibit 4)."
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And with many other traders and analysts also pointing out the rather odd decoupling between oil and junk bonds, Goldman proposed what it thought was the answer:
We think the much stronger resilience of energy credits both vs. their own recent history and vs. their equities counterparts reflects three key factors.
- First, the interaction between the trajectories of the spot and long-dated oil prices has been more damaging for equities relative to credit. For equity investors, the sharp decline in long-dated prices suggests the outlook for future earnings may have turned more challenging, causing a downgrade of the sector’s valuation. For bond investors, the focus remains more on production costs and efficiency gains, both of which have dramatically improved over the past few quarters. Based on 2016 data, our Credit Research Team estimates the cost breakeven level for their E&P coverage universe at $56/bbl vs. $68/bbl in 2015, a sizeable decline that highlights the magnitude of the efficiency gains since the onset of the New Oil Order, especially for shale producers.
- Second, credit quality for HY Energy issuers has improved over the past few quarters. Defaults have slowed down materially while the share of CCC-rated Energy bonds declined to levels that are in-line with historical norms
- Finally, refinancing risk is quite low while funding markets remain accessible for Energy issuers
Meanwhile, in late June UBS credit analyst Matthew Mish went one step further, and proposed that while largely oblivious to the recent moves in oil, High Yield credit would start caring once WTI dropped below $40:
12-month WTI at or below $40 will elevate 2015-style risks for HY energy. We estimate a sharp or sustained decline in 12-month WTI below $40 or so (vs mid 40s current) will bring back non-linear downside risks for U.S. HY energy. This is modestly below average breakeven oil prices for HY E&P firms. In addition, almost 30% of firms have only adequate liquidity and are dependent on external financing as hedges roll off.
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"If oil prices fall to $40 or below, the negative impact on rest of world profits (via commodity-related foreign subsidiaries of US companies) could be a material headwind for aggregate corporate profits, and a prolonged $40 oil price would trigger more stress and defaults in lower-quality HY issuers heading into 2018 (and could prompt banks to tighten lending standards on C&I loans at the margin). While lower oil prices should limit upside inflation risks, market expectations for Fed rate hikes are already well below the median path projected by the Fed, suggesting the market is priced for a dovish outcome already. A supply-driven drop in oil prices coupled with resilient equity markets and financial conditions could still have the Fed tighten policy more than the market expects."
Ah yes, the paradoxical world where an ultra-loose Fed is deflationary for oil prices as it enables U.S. shale companies to offset declining cash flows by bulking up their balance sheet with cheap debt. It will be amusing to watch if, as some have suggested, a sharp tightening by the Fed unleashes a surge in oil prices as shale balance sheets are no longer able to refi at ultra-low rates, putting many of them in bankruptcy and prompting OPEC's much desired marginal supply reduction.
But that is a bridge to be crossed on another day. For now, we wanted to bring readers' attention a follow up note from Goldman, 2 months after the first report pointing out the curious divergence between underlying oil prices and junk spreads, which asks the same question that UBS did in June, namely "when will HY start to care about oil", and notes that "the recent price action in the oil market and the stronger response of the HY Energy sector has prompted many market participants to question the ability of the broader HY market to continue to resist lower oil prices. In our view, the bar remains high for oil prices to become the main directional driver of HY spreads but the risk has risen."
Below are some additional observations from Goldman's Lotfi Karoui:
One way to quantify this risk is to examine any potential asymmetry in the way the HY market responds to moves in oil prices. Exhibit 4 takes this into perspective and depicts the response of HY weekly total returns (ex-Energy) to weekly crude price returns since the onset of the New Oil Order in 2014.
The left panel shows the impact of negative oil price returns while the right panel shows the response to positive oil price returns. The key message from Exhibit 4 is twofold. First, the response of the HY market to moves in crude is asymmetric. The impact of negative oil price returns on HY ex-Energy total returns is nearly double that of positive oil price returns.
So when will junk bonds notice? Somewhat not surprisingly, Goldman reaches the same conclusion as UBS: "taking the simple univariate regressions shown in Exhibit 4 at face value suggests a 20% decline in oil prices to sub-$40/bbl would cause HY ex-Energy total returns to decline by 2%. This estimate is obviously subject to uncertainty and the risk of a large decline in oil prices remains low. But as our commodities team discussed recently, data volatility continues to impact sentiment which renders the risk of large higher or lower moves in the short-term symmetrical.
It is worth pointing out that numerous strategists have suggested that any equity selloff would be prompted by a drop in credit first, where the high-beta junk space would be the catalyst for any potential crash. As such, it is interesting, and perhaps perplexing, that the fate of the U.S. stock market and Fed monetary policy, is now in the hands of Saudi Arabia, OPEC and, of course, U.S. shale producers. One wonders if they are aware of this, and just how much leverage they have as a result...
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