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If WTI Drops To $60, It Will "Trigger A Broader HY Market Default Cycle", Says Deutsche

Tyler Durden's picture




 

A month ago we wrote that with oil plunging, the flipside of the widely documented "secret" deal by Obama/Kerry with the Saudis to crush Russia with low, low oil prices, is that none other than America's own shale industry would be placed under the microscope soon, as its viability at a price well below the shale industry's cost curve is suddenly put in doubt.

We concluded that "while we understand if Saudi Arabia is employing a dumping strategy to punish the Kremlin as per the "deal" with Obama's White House, very soon there will be a very vocal, very insolvent and very domestic shale community demanding answers from the Obama administration, as once again the "costs" meant to punish Russia end up crippling the only truly viable industry under the current presidency. As a reminder, the last time Obama threatened Russia with "costs", he sent Europe into a triple-dip recession. It would truly be the crowning achievement of Obama's career if, amazingly, he manages to bankrupt the US shale "miracle" next."

Since then crude has continued to slide, and both Brent and WTI are now trading at a price where just a year ago would seem ludicrous: in the mid-$70s. And the future of America's "shale miracle" has only gotten ever murkier since a month ago.

But suddenly it is not just the shale companies that are starting to look impaired. According to a Deutsche Bank analysis looking at what the "tipping point" for highly levered companies is in "oil price terms", things start to get really ugly should crude drop another $15 or so per barrell. Its conclusion: "we would expect to see 1/3rd of US energy Bs/CCCs to restructure, which would imply a 15% default rate for overall US HY energy, and a 2.5% contribution to the broad US HY default rate.... A shock of that magnitude could be sufficient to trigger a  broader HY market default cycle, if materialized. "

Here are the details:

So how big of an impact on fundamentals should we expect from the move in oil price so far and where is the true tipping point for the sector? Let’s start with some basic datapoint describing the energy sector – it is the largest single industry component of the USD DM HY index, however, given this market’s relatively good sector diversification, it only represents 16% of its market value (figure 2). Energy is noticeably tilted towards higher quality, with BB/B/CCC proportions at 53/35/12, compared to overall market at 47/37/17. We find further confirmation to this higher-quality tilt by looking at Figure 3 below, which shows its leverage being around 3.4x compared to 4.0x for overall market. Similarly, their interest coverage stands at noticeably higher levels, even having declined substantially in recent years (Figure 4).

 

 

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.

 

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. This chart also shows, perhaps better than any other we have seen, the extent to which current economic  recovery in the US has in fact been driven by the energy development story alone.

 

 

The next question we would like to address here is to what extent the move in oil so far could translate into actual credit losses across the energy sector. To help us approach this question we are borrowing from the material we are going to discuss in-depth in next week’s report on our views on timing/extent of the upcoming default cycle. For the purposes of the current exercise we will limit ourselves to saying that we have identified total debt/enterprise value (D/EV) as an important factor helping us narrow down the list of potential defaulters. Specifically, our historical analysis shows that names that go into restructuring, on average, have their D/EV ratio at 65% two years prior to default, and, expectedly, this ratio rises all the way to 100% at the time of restructuring. From experiences in 2008-09 credit cycle we have also determined that there was a 1:3 relationship between the number of defaulting issuers and the number of issuers trading at 65%+ D/EV prior to the cycle. Again, we are going to present detailed evidence behind these assumptions in the next week’s report.

 

For the time being, we will limit ourselves to applying these metrics to current valuations in the US HY energy sector, and specifically, its single-B/CCC segment. 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.

 

Looking at the bond side of valuation picture, we find that energy Bs/CCCs are trading at a 270bp premium over non-Energy Bs/CCCs today (Figure 7). This premium implies incremental default rate of 4.5% (= spread * (1 – recovery) = 270 * (1-0.4) = 4.5%). Actual default rate among US HY Bs/CCCs is currently running at 3%, a level that we expect to increase to 5% next year (not to be confused with overall US HY default rate, currently running at 1.7% and expected to increase to 3.0% next year).

 

The bottom line is hardly as pretty as all those preaching that the lower the oil the better for the economy:

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. If this scenario were to materialize, based on historical default incidence, we would expect to see 1/3rd of US energy Bs/CCCs to restructure, which would imply a 15% default rate for overall US HY energy, and a 2.5% contribution to the broad US HY default rate.

How should one trade an ongoing collapse in oil prices? Simple: sell B/CCC-rated energy bonds and wait to pick up 10%.

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.

It gets worse, because energy CapEx is about to tumble, which means far less exploration (and US fixed investment thus GDP), far less supply, and ultimately a higher oil price.

As the market adjusts to realities of sharply lower oil prices, it is important for to remember that the US HY energy sector is a higher quality part of the market. Higher credit quality will help many of them absorb an oil price shock without jeopardizing production plans or ability to service debt. Their capex rates, expressed as a pct of EBITDAs, have already declined from an average of 150% over the past four years to roughly 110% today. We still consider this level to be high and thus subject to further pressures. This in turn should work towards slower rates of supply growth, and thus ultimately towards supporting a new floor for oil prices. A 25% in oil price so far has pushed debt/enterprise valuations among US energy B/CCC names to a point suggesting 8.5% future default probability, while their bonds are pricing in a 9.5% default probability.

And the scariest conclusion of all:

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.

And now back to the old "plunging oil prices are good for the economy" spin cycle.

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Thu, 11/13/2014 - 13:11 | 5444588 ekm1
ekm1's picture

No, they will not default.

Government will bail them out

 

Oil will go as low as $20, in my view

Thu, 11/13/2014 - 13:16 | 5444606 NoDebt
NoDebt's picture

"High yield energy sector" bonds are typically issued by smaller companies.  They will not be bailed out.  And definitely not by this administration.

If it goes systemic and starts affecting banks then yes, there will be bailouts per S.O.P.

Thu, 11/13/2014 - 13:51 | 5444808 KnuckleDragger-X
KnuckleDragger-X's picture

Most people don't realize that in the oil patch bankruptcy is common and all those rigs won't magically disappear. They'll go back to sitting in fields until the next gambler comes along except they won't have to be rebuilt for directional drilling. The drilling industry has always been a giant crapshoot.

Thu, 11/13/2014 - 14:34 | 5445110 max2205
max2205's picture

And then we can find out how many Enrons there are out there.

I am sure the SEC is on top of this

Thu, 11/13/2014 - 14:44 | 5445165 KnuckleDragger-X
KnuckleDragger-X's picture

To be a true Enron you have to hire Krugman.....

Thu, 11/13/2014 - 15:09 | 5445304 Deathrips
Deathrips's picture

Free Market Economics 101.

 

"Product price goes soo low that theres no supply availble."

 

Common core pay per view.

 

RIPS

Thu, 11/13/2014 - 14:49 | 5445194 Vampyroteuthis ...
Vampyroteuthis infernalis's picture

Libbies hate oil (even though no alternative exists). They will watch all the fracking companies implode around them while they bailout the worthless solar and other fraudulent alt. energy companies. Oil carnage coming soon to a street near you.

I live in Texas and the high oil price has buoyed the economy here compared to rest of the US. This will quickly change within the next few months.

Thu, 11/13/2014 - 15:58 | 5445397 Tall Tom
Tall Tom's picture

So you do remember the middle 1980s...the last time that the USA and the House of Saud punished Russia...excuse me...the USSR...with low Oil Prices.

 

Yeah...under Ronald Reagan...that Texas Real Estate Market collapsed as a result.

 

Of course...with competing in Star Wars...warring in Afghanistan...with their loss in revenue... so did the Soviet Union collapse.

 

We are just repeating the same stategy...AS IT WORKED BACK THEN.

 

There is always suffering in Warfare. However many Americans are going to enjoy this suffering while many other Americans will not enjoy it.

 

Obama is just saying "Fuck You" not only to the Russians... He is also saying "Fuck You to Texas, Oklahoma, and North Dakota....which are Red States.

 

He kills many birds with this policy. The rest of the nation will enjoy gas on the cheap...for awhile....until American production is stopped. Then watch the result of that.

Thu, 11/13/2014 - 17:12 | 5445816 sun tzu
sun tzu's picture

Once American producers go bankrupt the Saudis will jack the price back up to make up for all the losses and it will be $6 gas. Everyone cheering the pain of American oil producers will be crying as prices creep ip into all parts of the economy

Wed, 11/26/2014 - 15:40 | 5491858 astoriajoe
astoriajoe's picture

I think the U.S. had more gold then.

Putting more popcorn in the microwave.

Thu, 11/13/2014 - 13:17 | 5444614 Winston Churchill
Winston Churchill's picture

With what ?

Maybe Saudi will dump their UST's at that point.

That Qatari yuan swap was a precursor to something bigger.

It a no win situation.

Thu, 11/13/2014 - 13:19 | 5444623 ekm1
ekm1's picture

Oil in storage rehypotheticated for derivatives will be dumped, same as in 2008, in my view

Thu, 11/13/2014 - 13:21 | 5444635 Winston Churchill
Winston Churchill's picture

Further depressing the price, and raising the bankruptcy level.Plus reduucing federal and state

tax revenues bringing a widespread govt. default.

At that point China and Russia will dump their UST's.

Thu, 11/13/2014 - 13:25 | 5444652 ekm1
ekm1's picture

Dumping USTs leads to receiving USDs

Not much difference.

 

They would have to dump USDs.

How?

Thu, 11/13/2014 - 13:37 | 5444717 LawsofPhysics
LawsofPhysics's picture

Hold on a second you guys.  Take a step back, are defaults actually allowed anymore?

Thu, 11/13/2014 - 13:44 | 5444746 maskone909
maskone909's picture

exactly

and how does this not push the world further away from the dollar?

Thu, 11/13/2014 - 13:58 | 5444862 LawsofPhysics
LawsofPhysics's picture

To what exactly?  What part of all fiat go to zero don't people understand?

Thu, 11/13/2014 - 14:05 | 5444918 maskone909
maskone909's picture

who fucking knows.  shitcoins?  pogs?  all i know is alotta people will get hurt and go hungry

Wed, 11/26/2014 - 15:42 | 5491859 astoriajoe
astoriajoe's picture

POGS! awesome. +1

 

Thu, 11/13/2014 - 14:07 | 5444931 fuu
fuu's picture

The fact that they do not all go to zero at the same moment in time?

Thu, 11/13/2014 - 15:50 | 5445478 Tall Tom
Tall Tom's picture

No. Not at the very same instant. But time for all to fail will be compressed as it is an Exponential Function.

 

And since all Central Banks, both Foreign and Domestic, hold US Dollars in Reserve, as the US Dollar is the World Reserve Currency, When the Dollar goes down, any Banks left standing become insolvent rapidly.

 

So the US Dollar will be the last Domino. But it will not withstand the momentum of the fall of all of the others.

 

It is called Globalization and interdependency. It is not about me. It is about we. It is not that I support this. But it is that I report this.

 

Now there is a REASONABLE lack of faith, trust and confidence in that relationship as the partners have been cheating.. This leads to divorce and, following that, the fight for the assets of the relationship.

 

I am sure that many of you can relate to that from experience. Well it is no different except by scale of economies.

 

(Is my analogy better today?)

 

And ekm1...So you write that the USD cannot purchase anything of value? Perhaps the Saudis can buy GOLD. Or are you writing that it is worthless?

Thu, 11/13/2014 - 17:15 | 5445827 sun tzu
sun tzu's picture

You are right. Once one major currecy collaspes fue to loss of faith it will be like dominoes

Thu, 11/13/2014 - 13:28 | 5444657 Spastica Rex
Spastica Rex's picture

The endgame can be the most challenging and subtle part of chess.

Thu, 11/13/2014 - 13:40 | 5444733 Kaiser Sousa
Kaiser Sousa's picture

”Russia has taken advantage of lower gold prices to pack the vaults of its central bank with bullion as it prepares for the possibility of a long, drawn-out economic war with the West. The latest research from the World Gold Council reveals that the Kremlin snapped up 55 tonnes of the precious metal - far more than any other nation - in the three months to the end of September as prices began to weaken. Vladimir Putin's government is understood to be hoarding vast quantities of gold, having tripled stocks to around 1,150 tonnes in the last decade.

These reserves could provide the Kremlin with vital firepower to try and offset the sharp declines in the rouble. Russia's currency has come under intense pressure since US and European sanctions and falling oil prices started to hurt the economy. Revenues from the sale of oil and gas account for about 45pc of the Russian government's budget receipts. The biggest buyers of gold after Russia are other countries from the Commonwealth of Independent States, led by Kazakhstan and Azerbaijan.”

In total, central banks around the world bought 93 tonnes of the precious metal in the third quarter, marking it the 15th consecutive quarter of net purchases. In its report, the World Gold Council said this was down to a combination of geopolitical tensions and attempts by countries to diversify their reserves away from the US dollar. By the end of the year, central banks will have acquired up to 500 tonnes of gold during the latest buying spell, according to Alistair Hewitt, head of market intelligence at the World Gold Council.

"Central banks have been consistently adding to their gold holdings since 2009," Mr Hewitt told the Telegraph. In the case of Russia, Mr Hewitt said that the recent increases in its gold holdings could be a sign of greater geopolitical risk that has arisen since it seized Crimea sparking a dispute with Ukraine and the West.”

http://www.telegraph.co.uk/finance/commodities/11226240/Putin-stockpiles...

Thu, 11/13/2014 - 13:17 | 5444618 pods
pods's picture

What's the time frame on that ekm?  I want to be in my bug out spot a month or so before we hit that price.

pods

Thu, 11/13/2014 - 13:22 | 5444631 ekm1
ekm1's picture

It should have happened already.

It all depends on the central command and there is civil war at the central command.

 

Saudis no longer care about goldman or jpm or big banks. They want to destroy iran's economy

Thu, 11/13/2014 - 13:34 | 5444698 Winston Churchill
Winston Churchill's picture

Thats not going to happen.

Most people that haven't been there have not idea what Persians are like.They are not Arabs,

which has more to do with the Saudi emnity than the Shia/Sunni divide, which is a western

inflamed creation anyways.Iran is already insulated, ironically by US sanctions.

Thu, 11/13/2014 - 13:32 | 5444686 Bunga Bunga
Bunga Bunga's picture

$10, you read it here first.

Thu, 11/13/2014 - 13:43 | 5444739 malek
malek's picture

Yeah, but in current or future revamped US Dollar? (after HI)

Thu, 11/13/2014 - 13:58 | 5444855 Bunga Bunga
Bunga Bunga's picture

Fed had been printing for 5 years, so what is the Dollar waiting for?

Thu, 11/13/2014 - 14:36 | 5445124 Uber Vandal
Uber Vandal's picture

$10 dollars, do I hear $5,

FIVE, I hear Five.....

But seriously, it was $10 in the late 1990's.

Thu, 11/13/2014 - 15:57 | 5445522 Tall Tom
Tall Tom's picture

And Gold was at $260 in the late 1990s.

 

But it IS different this time. The amount of existing US Dollars has exploded. The amount of Gold has grown, but nowhere near the rate of US Dollar growth, and the amount of World Oil Resources have declined.

 

My bet is that we see $60 Oil. and $1000 Gold.

Thu, 11/13/2014 - 16:18 | 5445622 Uber Vandal
Uber Vandal's picture

I am looking at all of this as a big joke.

That would explain a lot lately.

At least to me anyway.

Thu, 11/13/2014 - 13:46 | 5444769 Bell's 2 hearted
Bell's 2 hearted's picture

i didn't realize the energy sector had a large union presence ...

Thu, 11/13/2014 - 13:12 | 5444589 NoWayJose
NoWayJose's picture

Frackers and ISIS and Iran and Russia are outside big bank control -- some thing must be done!

Thu, 11/13/2014 - 13:13 | 5444590 Quinvarius
Quinvarius's picture

Good job Obama.

Thu, 11/13/2014 - 13:14 | 5444597 NoDebt
NoDebt's picture

That's the best news I've heard all day.

Thu, 11/13/2014 - 13:15 | 5444602 Colonel Klink
Colonel Klink's picture

Zzzzzzzzzzzz...please wake me when it happens.  First a war of words, then a war of currency, then when resources stop crossing borders, war.  Rinse, repeat.....teh oligarchs.

Thu, 11/13/2014 - 13:21 | 5444630 anachronism
anachronism's picture

If WTI goes down to 60 and if it stops there, I would begin to believe the price manipulation story.

At 60, only the oil majors and Saudi Arabia will be still be profitable. Much below 50 and just about everybody will be losing money.

If the pice hovers around 60 for a few months, it will provide the oil majors with a unique opportunity to buy up some proven reserves that have are ready been developed by companies that are strapped for cash. Additionally, many oil service companies could be drastically depressed.

It will b e a great time for the oil majors and for private equity leveraged buyouts. Goldman Sachs and the descendants of Standard oil will be elated.

Thu, 11/13/2014 - 13:23 | 5444643 MATA HAIRY
MATA HAIRY's picture

I blame presedint Obola@!!@#@#@#!!!!11

Thu, 11/13/2014 - 13:25 | 5444651 Jack Sheet
Jack Sheet's picture

Bring it on. It's all a shale game

Thu, 11/13/2014 - 13:29 | 5444656 Never One Roach
Never One Roach's picture

I heard some Big Wig exec from one of the smaller O&G Houston companies on TV say if oil goes below $80 the smaller companies [like his] will start to hurt. I think he said his was a small fracting company of sorts working in North Texas Oklahoma area but I can't exactly remember where.

He said that would not be good news for Houston area [which is a massive energy hub] but he indicated the city may be diverse enough with other industries like health care, education, etc. to withstand a O&G downturn.

 

Houston has been one of the 'robust' areas of growth [like Cali] with solid RE market but my cousin who works there said this may dent that.

Thu, 11/13/2014 - 13:31 | 5444683 Seize Mars
Seize Mars's picture

That's funny, did they say anything about PM prices impacting the miners? Any knock-on effects of that?
LOL

Thu, 11/13/2014 - 13:32 | 5444688 papaswamp
papaswamp's picture

Couple of Radicals attack pipelines and ports in Lybia, iraq and Saudi and things will run back up to the $80s. Just watch...just in the nick of time some geoplotical event. Maybe even Russia with full on push in Ukraine.

Thu, 11/13/2014 - 13:36 | 5444701 Colonel Klink
Colonel Klink's picture

I also have to add, anything coming from Douche Bank or Golden Ballsachs I'd take with a salt mine of NaCl.

Someone (not the little people) are setting up to profit from this move.  More than likely the banksters and politicians (CONgresscritters).

Thu, 11/13/2014 - 13:36 | 5444711 miker
miker's picture

As more and more financial insight is exposed on fracking fundamentals, it is becoming pretty obvious that this industry has some "special" support.  That special support being the highest levels of the Federal Government.  Why?  1)  Develop domestic supplies for energy emergency/security.  2)  Promote energy "independence" and optimism.  3)  Create jobs.

Doesn't matter if it's not all a big money maker.  The tremendous debt to fund the fracking will ultimately be backstopped by the Fed, when it is needed.  

Consider this another covertly subsidized industry; kind of like the unbelievable apartment boom taking place across the country.  Same story.

Thu, 11/13/2014 - 13:37 | 5444712 vote_libertaria...
vote_libertarian_party's picture

'terrorist attacks' in Saudi Arabia and Iran in 3...2...

Thu, 11/13/2014 - 13:39 | 5444724 Bell's 2 hearted
Bell's 2 hearted's picture

i used to kid that goldman sachs had Kim Jong on retainer ... and would have him launch a missile anytime they needed to move price of oil

Thu, 11/13/2014 - 13:38 | 5444713 Bell's 2 hearted
Bell's 2 hearted's picture

"If"?

Thu, 11/13/2014 - 13:38 | 5444716 TheRideNeverEnds
TheRideNeverEnds's picture

110--->75 = cheap energy, new paradigm, its like a tax cut for the little people! bullish! 

 

75--->65 = here be dragons, systemic risk, global deflation, the end of days.  bearish!

 

got it.   

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