Tight Oil’s First Domino

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.

As we said before, the so called tight oil revolution is predicated upon 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 credit markets. As the price actions this past week brought the price of oil below the psychological $60 level, the capital markets, namely stocks and bonds in the energy sector, are feeling the full brunt of shock and awe.

Witness in the chart below the blowout of the spread to close to 1000 basis points between the energy high yields and the safety of treasury. The contagion from the energy sector is causing the yield of the entire HY sector to rise sharply higher.

HY spreads
Energy high yield bond spreads (source: ZeroHedge)

Don’t think the carnage will be limited to the energy sector if oil prices stay depressed for a long time. The fact that the tight oil industry has been one of the key employment drivers in the US and that a lot of banks, pension funds and individual investors have plowed a huge amount of money into this sector will virtually guarantee that the hurt inflicted on the domestic economy and many portfolios will be spread far and wide.

To wit:

  • Some $550 billion has been poured into this sector in the past few years in the form of stocks and bonds.
  • If oil stays at $60 a barrel, about 30% of the HY names will likely default (total energy HY just under $200 billion), as predicted by a recent Deutsche Bank analysis.
  • In the US, the energy sector is responsible for about one third of S&P capex. The oil majors are already announcing capex reductions for  2015 ranging from 10 to 20%, likely higher for the juniors (impact on employment in the oil sector?)
  • A lot of drillers and juniors will find it increasingly difficult if not impossible to access capital in a bidless market and are forced to scale back, sell assets to raise cash or shut down.

How is it possible to have yet another round of capital destruction such as this one happen, when the subprime housing bubble popped only less than a decade ago?

It is almost like a replay of 2008 by a similar cast of central banks, investment community, mainstream media and investment public:

  • Central banks of the world printed trillions out of thin air to bail out the investment banks while suppressing interest rates from zero to even negative in the process.
  • In a desperate search for income, yield starved investors are forced to venture into the shaky end of the risk spectrum where they do not belong.
  • Conflicted investment analysts tout the shale revolution and oil independence memes to pump up the markets to allow them to dump their bond and stock offerings to uninformed investors. The mainstream media cheer along.
  • Massive amounts of money get plowed into the shale energy sector.
  • Corporate executives of these companies compensate themselves with huge salaries and generous stock options. Insiders exercise their stock options, sell their stocks, and exit stage left.
  • The drop in oil prices exposes the questionable business case of the shale oil sector, resulting in much the same way the subprime crisis unfolded in 2008.
  • Investors are left holding the bag.
  • Onto the next bubble idea. Repeat and rinse.

Perhaps we will learn – one day.

References:

 

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