Just two weeks ago, we noted that chasing after high yield debt from beleaguered junior oil producers was likely not the best idea [17] given the fact that geopolitical logrolling, surging supply, and shrinking storage capacity all point to further declines for crude. More specifically, we said the following in an update to a post in which we outlined what a tiny Colorado shale play has in common with a long-gone movie rental chain:
Update: And just to prove that people are indeed, idiots, moments ago this hits:
ENERGY XXI GULF COAST, INC. PRICES UPSIZED PRIVATE OFFERING OF $1.45 BILLION OF 11.000% SENIOR SECURED SECOND LIEN NOTES DUE 2020
As it turns out, we were right to be skeptical because, as Bloomberg reports [18], these very same notes have cost investors $7 billion in just 10 days:
Investors lured back into junk-rated energy bonds by their juicy yields are getting burned.
Oil prices have fallen more than 15 percent since March 4 to a six-year low of $43.5, wiping out $7 billion of market value of high-yield debt issued by energy companies. Prices on $1.45 billion of notes sold less than two weeks ago by Energy XXI Ltd., an oil producer that was being squeezed by its lenders, have fallen by as much as 10 percent…
Oil producer Energy XXI’s second-lien bonds, issued on March 5 to repay borrowings under its line of credit, slid below 90 cents on the dollar on Tuesday after trading as high as 99.9 cents, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
The Houston-based company attracted investors by selling the 11 percent notes at a discount to yield as much as 12 percent. That’s almost double the average yield on all U.S. junk bonds, according to a Bank of America Merrill Lynch index.
The losses come at the expense of investors trying to call a bottom in crude prices and much as everyone who piled into oil ETFs [19] while being simultaneously oblivious to the fact that the market was in the widest contango in four years subsequently suffered for their ignorance, so too will the yield-starved buyers of oil junk bonds take a beating for thinking that “buy the dip” is a viable investment strategy:
Junk-rated energy borrowers have sold about $9.4 billion in bonds this year, doubling the amount issued during the last three months of 2014, according to data compiled by Bloomberg. The companies raised more than $17 billion during the third quarter of last year.
Oil prices are plunging as U.S. output climbs to the highest in three decades even as explorers idle drilling rigs. The drop to less than $44 a barrel follows a month of relative stability, when prices hovered around $50 after sliding from as high as $107 in June.
The slump has eaten into February’s 2.3 percent gain in junk bonds, which was the biggest advance in 16 months, Bank of America Merrill Lynch index data show. The average speculative-grade rated note has tumbled 1.1 percent in March.
“Oil prices are having an impact again in the high-yield market,” Jim Kochan, chief fixed-income strategist at Wells Fargo Funds Management, said in an interview. “There were a lot of experts who thought that oil prices had fallen too far and that they would correct. Instead, now we’re seeing a downdraft.”
Meanwhile, the same companies that are offering investors double-digit yields may ironically be shooting themselves in the foot (and, as we suggested last month, contributing to disinflation [20]) because as the Bank For International Settlements notes [21], keeping current on debt payments often means maintaining elevated production...
A new element that can help shed light on this question is the high level of debt of the oil sector. The debt borne by the oil and gas sector has increased two and a half times over, from roughly $1 trillion in 2006 to around $2.5 trillion in 2014. As the price of oil is a proxy for the value of the underlying assets that underpin that debt, its recent decline may have caused significant financial strains and induced retrenchment by the sector as a whole. If the adjustment takes the form of increased current or future sales of oil, it may amplify the fall in the oil price. Similarly, if the need to service debt delays a pullback in production, a lower price may act more slowly to balance supply and demand.
...because keeping a leverage-driven bubble inflated means doubling and tripling down...
As regards financial constraints, the price decline occurred against the backdrop of much higher debt levels of oil producers. By analogy with the housing market, when the underlying assets of a leveraged sector fall in value, the strain imposed by the price decline induces retrenchment - for instance, by trying to sell more of the asset backing the debt.
… and this is exacerbated by investors’ willingness to take on risk if it means squeezing out a few basis points of yield versus “safer” debt which, depending on where you look, may actually produce loses thanks to NIRP…
The greater willingness of investors to lend against oil reserves and revenue has enabled oil firms to borrow large amounts in a period when debt levels have increased more broadly due to easy monetary policy. Since 2008, companies in the oil sector have borrowed both from banks and in bond markets. Issuance of debt securities by oil and other energy companies has far outpaced the substantial overall issuance by other sectors. Oil and gas companies' bonds outstanding increased from $455 billion in 2006 to $1.4 trillion in 2014, a growth rate of 15% per annum. Energy companies have also borrowed heavily from banks. Syndicated loans to the oil and gas sector in 2014 amounted to an estimated $1.6 trillion, an annual increase of 13% from $600 billion in 2006.
In the end, we get a high yield market awash in paper floated by US-listed juniors...
Overall, the stock of debt of energy firms has risen even faster than that of other sectors. Debt issued by oil and other energy firms accounts for about 15% of both investment grade and high-yield major US debt indices, up from less than 10% just five years earlier...
US oil companies have… borrowed heavily. They account for around 40% of both syndicated loans and debt securities outstanding. Much of this debt has been issued by smaller companies, in particular those engaged in shale oil exploration and production. Indeed, while the ratio of total debt to assets has been broadly unchanged for large US oil firms, it has on average almost doubled for other US producers - including smaller shale oil companies.
[22]
...which, as we noted six months ago, absolutely will not end well…
The combination of falling oil prices and higher leverage can lead to financial strains for oil-related firms. First, the price of oil underpins the value of assets that back these firms' debts. Lower prices will tend to reduce profitability, increase the risk of default and lead to higher financing costs. Indeed, spreads on energy high-yield bonds widened from a low of 330 basis points in June 2014 to over 800 basis points in February 2015, much more than the increase for total high-yield debt (Graph 3). Second, a lower price of oil reduces the cash flows associated with current production and increases the risk of liquidity shortfalls in which firms are unable to meet interest payments.
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We would also note that all of the above serves to validate what we said in January [23], which is that as long as easy money policies are effectively subsidizing otherwise bankrupt shale companies, don't expect prices to rise anytime soon:
OPEC will not cut alone, or in other words, as long as shale companies are out there pumping, kept alive thanks to the Fed's ZIRP policy forcing investors to keep them well capitalized even though bankruptcy may be breathing down everyone's neck in short order, expect the Saudis to keep pumping at the same feverish pace…
Ironically, it may well end up as a showdown between the Fed and Saudi Arabia, the former doing everything in its power to keep otherwise insolvent companies well-capitalized, and on the other Saudi Arabia doing everything in its power to keep the cash flow drain as high as possible for High Yield debt-funded shale companies, and daring either the Fed, or rather junk bond investors who are scrambling for any source of yield, to back out.
