Great Unwind of Oil-and-Gas Junk Bonds to Defund Fracking Boom

Wolf Richter's picture

Wolf Richter   www.wolfstreet.com   www.amazon.com/author/wolfrichter

The price of oil plunged once again off the chart on Monday and early Tuesday. At one point, West Texas Intermediate traded below $54 per barrel, though it soon bounced off. Crude is down nearly 50% since June. And over-indebted energy companies with cash flows that range from increasingly uncertain to completely demolished are suddenly contemplating just how deep the abyss might be.

The below-investment-grade bonds these risky companies issued with enormous hoopla and hype to fund the shale revolution and offshore drilling projects, lovingly dubbed “junk bonds,” had been sold to investors on the premise that oil would sell for ever increasing prices in the future, with the understanding that this might allow the company to make interest payments on time and raise new debt to pay off the old debt when it matures.

Even the still uncertain economics of fracking – the expense of drilling coupled with the horrendous decline rates – or the potential environmental consequences and subsequent backlash were elegantly shrugged off on Wall Street, given the ever increasing price of oil.

And investors loved the slightly higher yields these bonds offered in an era when the Fed and other central banks have conspired to expunge yield from the system with the express purpose of pushing investors ever further out into riskier and riskier bets. Investors, driven to near insanity by these central-bank policies, went for the junk bonds with gusto, and it turned into a feeding frenzy that pushed yields down even further, encouraging companies to issue more and more junk at lower and lower yields.

Now the price of oil has plunged by nearly half. None of the equations work any longer. Sure, oil companies have hedged some of their production at much higher prices, and few are fully exposed, at least not yet, to the wrath of the oil-price collapse. But some of their production is already exposed, and in the future more and more of their production will be exposed.

Then what? The answer hovering in the room for junk bond investors, which includes conservative-sounding bond funds that people have in their retirement portfolios: default. A very unappetizing thought.

So investors are losing their appetite for oil and gas junk bonds. As they dump this suddenly crappy-looking paper and as they unwind this once magnificent bubble, prices drop and yields soar. This chart by S&P Capital IQ’s HighYieldBond.com shows just how rapid the decline has been: in July, energy junk bonds (red line) were still trading above 105 cents on the dollar, outperforming overall junk bonds (blue line) during the peak of the junk-bond bubble. Then the Great Unwind set in:

US-junk-bonds-energy-v-ex-energy

During these times of turmoil in the oil patch and on Wall Street, scores of bond issues become illiquid, and “price discovery” sets in where buyers and sellers are so far apart that no trades take place. And if forced selling sets in, prices collapse entirely. It’s brutal out there.

It’s a big market: energy junk bonds make up over 15% of the $1.3 trillion high-yield market. The rout has started to drag on the overall junk-bond bubble, and junk bonds ex-energy are now also declining.

At the riskiest and erstwhile frothiest end of the overall junk-bond market, it’s getting outright ugly: the effective yield index for bonds rated CCC or lower jumped from the record junk-bond-bubble low of 7.94% in late June to 11.72% on Monday. An increase of nearly 50% in funding cost for companies in that category. Here is a two-year chart with that beautiful spike :

US-Junk-bonds-CCC-2014-12-15

Junk bonds provided $1.3 trillion in funding to risky companies of all stripes, some of which are in terrible shape and likely to default in the near future. But oil drillers saw their revenue model suddenly cut in half, and this scares investors.

They know their favorite junk bonds get in trouble for two reasons:

  • When the oil-price plunge decimates the cash flow from unhedged production, and drillers have trouble making interest payments.
  • When a bond matures that was issued at a yield of, for example, 6% and has to be refinanced at 12%, just when revenues are plummeting while drilling costs remain the same, which might make it impossible to refinance this debt.

Leery investors see this, and they try to bail out of the riskiest end of the market, or they start demanding much higher yields to be enticed back in. In the process, they effectively turn off the cheap-money spigot these companies have become addicted to, and must have access to in order to survive. If this process continues, investors are effectively defunding parts of the fracking industry, precipitating the very events they’re so scared of.

The plunge in the price of oil is good for consumers, and so Wall Street promises a big boost to US GDP. But what have these folks been smoking? Read…   This Is Why the Oil-Price Crash Will Maul the US Economy

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TheGreatRecovery's picture

I wonder how many countries the world's biggest consumer can trade-sanction before trade drops off to a point at which so little is being railed to seaports and shipped to the world's biggest conumser that oil consumption for transportation decreases enough that the price of oil goes down (as it has).

Also, when Bush/Cheney invaded Iraq in 2003, Iraq's oil infrastructure was in extreme disrepair (on account of the BushSr and Clinton sanctions).  I would assume that the infrastructure is all fixed now, and therefore Iraq is pumping more, and therefore supply is larger.

Stud Duck's picture

Having over 7K acres of mineral rights in a county of Oklahoma where, as the most respected minerial geologist in Oklahoma, stated "the is no such thing as a dry hole" I do not worry about this latest bust. It actually provides another unique opportunity. You see, these oil companies lease those mineral rights for 3 years,  usually drill for oil and get gas. When it is not a productive venture, they fail to meet the terms of the contract of the lease, which is produce gas and oil.

One simply sets back, waits for the least to expire w/o production and if they fail to lease for another 3 years (they usually don't because of the crash in price or got broke) If they don't , I simply go the the county court house, remove the lease filed due to no preformance and free the section up for re-lease.  The original lease holder tries to hold the lease, but I simply provide the circuit court with a copy of the lease, ask the lease holder to provide proof of production, the can;t and the court acts accordingly, (that happen unless the judge is in their pockets). Most of the local judges have interests in mineral rights or their families do in that small county do and it is usually a simple process.

When you have 7,000 plus aces of minerial rights in Beaver County, Oklahoma, with production costs less than $14 per bbl. you don;t sweat the small stuff. I know that new tech is on the way to produce 4 times more oil than has already been produced since the early 60's, I know my kids and grandkids will have a "little extra" to provide education, down pmt on a house, ect. I have experienced at least 4 booms and busts, this is not a new type of event, just that more dumb asses getting their ass burned. Example, G W Bush in the 1980's with Midland Oil, bailed out by the Bin Laden family. I terminated their leases back then also.

LawsofPhysics's picture

Yep.  Turns out rural America isn't as dumb as everyone thinks we are.  With almost 35,000 acres mineral rights and water rights to several tributaries I can't up-vote this enough.

I've always wondered how southern California and Arizona were going to fare when Colorado, Utah, Montana and Idaho shut off the water.  This is something the people still ignore.

Stud Duck's picture

Yeppers, Laws of Physics, I am going to have to one up you on the mineral rights, as the ranch my Dad left me in Colorado is 34,000 acres, just leased it for gas exploration, knowing that it has already been drilled in the 1950's, actually aquired the oil exploration maps that were left out there in an old box car used for storage. I actually remember when they did drill to find out what was there in the late 50'sw early 60's.  It is lots and lots of gas located close to the Colorado Interstate gas line.

As far as water rights, sold them long ago, used the proceeds to purchase good land that it rains on most of  the time and don;t have to irrigate it. It is also some of the best grassland in the USA, Here in Central Missouri. We never looked back on that decision and when I go out to visit, I remember how it looked when I grew up there and what it looks like now, dry desert!

Here is a news article I ran across on what California has to look forward too. I wish the people of California would just visit Crowley County Colorado to see what there future looks like.

Here is the link to what their future holds!

http://www.5280.com/crowley/

TheGreatRecovery's picture

 THAT is patriotism (in my deservedly-humble opinion).

Setarcos's picture

Usual spot-on article by Wolf

Sirius Wonderblast's picture

So who's AIG this time round? When supply tanks, what effect on cost and the wider economy? Who gets to pick up the assets for bugger all?

HYMN's picture

Seems to me like some big "make believe" money guys have out smarted themselves. Could it be.... No bonuses in the oil patch this xmas.

hedgiex's picture

Yes. The anticipated but what WS will call unintended consequence of falling oil price has led to the spike in the US $ and Try. A classic flight to quality with the World not yet having an alternative in place.

$ rise is not good for external debt. It ballons it. WS wants to smoke up consumption with even more debt ?

lester1's picture

Isn't Citi on the hook for $800+ million worth of fracking junk bonds?

 

Perhaps that's why Jamie Dimon was begging for that bailout provision in that crappy omnibus spending bill..

starman's picture

Bofa ... bammm!

delivered's picture

Point well taken on the fact that a number of oil companies have hedge their production at higher prices but remember two key items. First and most importantly, who or what organizations are at the other end of the hedge (i.e., who is the counter party in this mess)? I have to figure there are some real problems brewing for these groups. Second, if oil stays low for a prolonged period, hedging really doesn't work that well and you may see oil companies take production off line in hopes of an oil rebound. But of course this will hammer revenues and cash flows and thus drive debt defaults which should begin to materialize in the 1st quarter of 2015.

There's generally a lag between an event such as decreasing prices and debt defaults due to the timing of how financial information is reported and how companies effectively execute a pre-packaged BK by prioritizing creditors of most important and stiffing creditors of least importance. Right now, you have to figure the weaker oil producers are developing their plan to "communicate" some soured rather than sweet results (no pun intented) to investors and debt holders alike with the goal of effectively telling them to suck it up right now and work with the company (in hopes of ever seeing any return) as they work through their options. The real impact on the debt side of life isn't going to be this month or maybe not even in early 2015 but rather when the following occurs:

- Cash/liquid resources are used to float the company for a while as it burns cash.

- Fracked wells oil production decline rates start to set in (driving revenue lower) after the first year or two which cannot be offset by new wells (as no capital is available to drill).

- Large write-offs of capitalized assets (tangible and intangible) occur as the required positive cash flow to support the original investments dies. When these assets are valued, it is primarily based on discounted future cash flows. So its safe to say there are alot of over valued assets on the balance sheet right now that need to be cleared off.

Should be a real fun year for the auditors as they attempt to determine if the proper value of the oil companies' assets, and the amount of right downs/offs, all the while battling with company management attempting to ensure the balance sheet is maintained in order to avoid blowing through any covenants.

I went through this in 1986 and 1987 when I worked for Coopers & Lybrand in Denver and got assigned to oil company accounts. The very first letter that always went out was to the banks/financing groups with only one requirement. That is, are you going to waive the convenant defaults for the current year. If yes, the audit proceeded. If not, well the dreaded "going concern" opinion was fired-up (and the company was still audited so the fees could be generated). 

 

Setarcos's picture

Good observations.

Does this presage "the final countdown" to the end of Financialism, the biggest Ponzi Scheme ever?

I fancy that it does and fear that the Cabal may use the Samson Option, as war againt Russia keeps gettng hyped.

Wahooo's picture

I'll be spending some time over the holidays finding the babies that were thrown out with the bath water. There are some very reasonably priced bonds from companies with decent balance sheets. Can't wait.

Johnny Moscow's picture

good insights. 

I think the Saudis are playing with fire and might not know that they just potentially put the world in recession in 2015. The energy patch is getting killed. Energy is basically what drove the US economy the past few years and it's dead at the moment given oil prices. HY energy junk is getting crucified especially and if this continues all these companies can't be profiltable even in the short term. Hedging can't work for much longer, and so we're looking at more layoffs, bankruptcies and writedowns at the banks and asset managers. That will surely kill off a lot of growth. 

And that doesn't even take into account what Russia will do.

 

marathonman's picture

The world was already going into recession in 2015.  The Saudis are just one player out there and they are just playing the cards they got.  No Saudi royal wants to end up with his head on a pike at the local mosque so they have to keep producing to fund the freebies to the Saudi layabouts.  The long term benefit is US shale is squashed.  The short term downside is that global financial contagion might kill profits.  Profits were already an issue since the Fed 'quit' the outright debt monetization. 

All right, all right, the plot thickens.  Grab the popcorn.

Duc888's picture

 

 

 

awwwwwww, so it turns out that "investors" can't make money off of this skim?  Cry me a river.

 

kchrisc's picture

Most know that the Zionist west has engineered the oil price decline to undermine Russia in Greater Israel's battle for Lebensraum in Syria.

With that said, I can assure all that the Zionist banksters are gleefully snapping up the fracking assets for pennies on the dollar as they go bust. They'll be gleefully running or selling those same assets for dollars on the pennies when the engineered oil price decline ends.

Just like what they do to the farmers  >> "Print. Loan. Crash. Take. Driver's seat.

An American, not US subject.

Johnny Moscow's picture

There are so many factors and variables at play here but off hand I was just thinking the following:

-The Saudis killed two major competitors and threats to them - Iran and Russia - with one stone of increasing production. They are scared of ISIS too (despite probably funding some of them and helping them come about) and would like nothing better for Syria to go down to lessen Iran's power (esp after seeing how much influence Iran has now in Iraq)

-low oil prices really pressures Russia and the US is in full favor of that for the most part. Results are probably even worse than they ever could have thought given the ruble's drop and now probably the US are wondering if by allowing this it's gone too far. That's both on account of the Russian situation and the fact that they have pretty much gutted the fracking and oil sands producers or soon will if these prices remain low for another year or so

-Russia somewhat thwarted the US in Syria and both the Saudis and US would love to see Syria fall to weaken their ties to Iran and also remove that gas pipeline that Russia was putting through Syria

-US could have given a shit about the frackers, But given what's happened I don't think anyone understood just how much damage destroying that part of the energy patch has and will continue to do. Think we're now taling about undoing all that energy industry job growth and hitting the US economy with a hammer next year, even despite the consumer having a little more in their pockets due to low oil prices

-once the E&P guys get stretched and bond prices start to drop precipitously and we see mass defaults look out. Lot of banks will get hit and the HY market will take a dive too. Then that will spill over into the rest of the economy and we'll be back to where we started a few years ago, but with way more debt and fewer "real" jobs.

 

logicalman's picture

Boom - Bust cycle.

The only way not to lose, short of being 'connected', is not to play the game.

 

Paveway IV's picture

You're not looking on a far enough timeline, kchrisc. If you go back to pre-9/11 oil prices, you'll see that oil is about back to where it belongs. I don't know why nobody thinks of this in terms of the oil bubble popping.

Killing a million Iraqis for Israel's oil pipelines upset the markets for a decade or so. That allowed them to double prices for an extended period of time. What you're seeing now is nothing but the tail end of a decade of oil demand destruction.

Chad_the_short_seller's picture
Chad_the_short_seller (not verified) Dec 16, 2014 7:12 PM

When is someone going to come up with WHO owns this crap???????????? We knew that NEW, LEND, AHM owned all the worthless gatbage that took them to zero but when is a real G gonna step up and let us know? I have found BOKF but I want to hear more dammit!!! Don't make me go gantsta on dat white ass

KnuckleDragger-X's picture

We'll know who they because they will be the ones screaming 'bailout'......

Setarcos's picture

Maybe even the Rothschild Dynasty at the top of the pyramid?  That'd be worth seeing after 250 years of extortion, with nothing and no one to extort from anymore.

Hey!  They and their associates really need us after all, to build and maintain their palaces and to pay their private income tax, which they call "interest".