A Nightmare Price Scenario for Tight Oil
Series: Tight oil's first domino
In a what-if analysis, Deutsche Bank calculates the price threshold of oil below which would not only cause catastrophic events in the high yield bond market where tight oil companies raise their capital, but also send a shock wave across the entire high yield bond segment.
The tight oil revolution is brought on by cheap debt and leverage. Should it unravel one day, then it would not be surprising that the first domino to fall will likely be from the capital markets.
As tight oil and gas companies kick the bucket, the contagion begins to spread to the banks with significant loan exposures to the energy sector.
In response to my last article in which I made the case of how an $80 ‘depressed’ oil price would wreak havoc on the tight oil miracle, someone asked why can’t the tight oil operators just hunker down and wait for the cycle to pass.
The short answer is they can’t, because of leverage.
Since the shale oil business model is predicated on OPM (other people’s money), it would be logical to complete the argument by presenting a perceptive from the investment community.
But first a quick recap from the last article:
- At the current price level of around $80, a few companies operating in selective sweet spots would still be making money. A good many of them, however, would be barely treading water or downright losing money.
- Seven years into the so called tight oil revolution, these companies are still bleeding cash and have yet to demonstrate that it is a commercially viable business. That’s when oil has been trading north of $100.
- Up to now, the negative net cash flow has been plugged by a huge amount of debt the tight oil industry has been able to raise via high yield (HY, aka junk) bonds and public offerings
- If oil prices stay depressed longer, more and more folks in the investment community would start to question the viability of this sector, further restricting these companies’ ability to raise additional debt at low rates.
- HY spreads between energy and non-energy have blown out by 270 basis points in the past month reflecting the poor outlook of the energy sector.
Energy vs non-energy high yield bonds
Nightmare Price Scenario
Deutsche Bank recently conducted a what-if analysis to see what ‘theoretical’ price threshold would trigger a ‘tipping point’ event to the highly leveraged tight oil operators, and, particularly, what that tipping point could mean to the energy high yield sector in particular and the entire HY in general.
- The energy sector HY (bonds graded BB/B/CCC) are generally considered high quality compared to the rest of HY as a whole. Until recently, that is.
- Assumptions & methodology – DB uses the debt to enterprise value (D/EV) as a predictor of future defaults. According to historical data, names that go into restructuring on average have their D/EV at 65% two years prior to default.
Here’s what DB said, per Zero Hedge:
Energy issuer leverage has increased faster than that of the rest of the market in recent years, but this trend has largely exhausted itself in recent quarters. As Figure 5 demonstrates, growth rates in total debt outstanding among US HY energy names have been only slightly higher relative to the rest of HY market. It is almost certain in our mind that with the current shakeout in this space further incremental leverage will be a lot harder to come by going forward.
Translation: the appetite for energy sector HY is getting saturated and will only get worse with the ongoing poor oil price actions.
Perhaps the most unsustainable trend that existed in energy going into this episode shown in Figure 6, which plots the sector’s overall capex expenditure, as a pct of EBITDAs. The graph averaged 150% level over the past four years, clearly the kind of development that could not sustain itself over a longer-term horizon. Our 45%-full sample of issuers reporting Q3 numbers has shown this figure coming down to 110%, a move in the right direction, and yet a level that suggests further capacity for decline.
- In the past four years, these companies have been spending $1.50 on capex for every $1 of revenue. And that is before interest payments on the bonds issued.
- Further pressure to bring down capex will inevitably result in lower future oil production. Remember tight oil is extremely capex intensive.
At the moment, average D/EV metric here is 55%, up from 43% in late June, before the 26% move lower in oil. About 28 pct of energy B/CCC names are trading at 65%+ D/EV, implying an 8.5% default rate among them, assuming historical 1/3rd default probability holds. This would translate into a 4.3% default rate for the overall US HY energy sector (including BBs), and 0.7% across the US HY bond market.
Translation: the sector is in significant distress at current oil price levels.
In the next step we are attempting to perform a stress-test on oil, defined this way: what would it take for overall US energy Bs/CCCs segment to start trading at 65%+ total debt/enterprise value? Our logic in modeling this scenario goes along the following lines: if a 25% drop in WTI since June 30th was sufficient to push their average D/EV from 43 to 55, then it would take a further 0.8x similar move in oil to get the whole sector to average 65 = (65-55)/(55-43) = 0.8x, which translates into another 20% decline in WTI from its recent low of $77 to roughly $60/bbl.
Translation: $60 oil is what it takes for the overall energy HY segment to start trading at 65% D/EV. That’s a further 20% decline in oil prices from the current value.
If this scenario were to materialize, the US energy Bs/CCCs would have to trade at spreads north of 1,800bp, or about a 1,000bps away from its current levels. Such a spread widening translates into a 40pt drop in average dollar price from its current level of 92pts for energy Bs/CCCs.
Translation: all of a sudden terms like ‘bloodbaths’ and ‘wipe-outs’ are starting to fly.
Finally, our stress-test shows that a further 20% drop in WTI to $60/bbl is likely to push the whole sector into distress, a scenario where average B/CCC energy name will start trading at 65% D/EV, implying a 30% default rate for the whole segment. A shock of that magnitude could be sufficient to trigger a broader HY market default cycle, if materialized.
Translation: at $60 per barrel, the entire energy HY sector will be pushed into distress with a 30% default rate. This shock wave will not be contained just within the energy sector but will spread across the whole HY market.
How likely is oil sustained at $60 per barrel? At $80 most oil producing countries are unable to balance their fiscal budgets. But then it does not mean a geopolitically motivated Saudis would not push the price this low for pure rational, economic reasons.
Perhaps the Saudi prince might get a tap on the shoulder soon. Or some grass root groups in the kingdom might start a ‘democracy movement’ and, coincidentally, disrupt local production there?