But, but, but... all the clever talking heads said they wil have to cut...
- *OPEC KEEPS OIL PRODUCTION TARGET UNCHANGED AT 30M B/D: DELEGATE
WTI ($70 handle) and Brent Crude (under $75 for first time sicne Sept 2010) are collapsing... as will US Shale oil company stocks and bonds (and thus all of high yield credit) tomorrow. The Saudis are "very happy" with the decision, Venzuela 'stormed out, red faced, furious.' Commentary from various OPEC members appears focused on the need for non-OPEC (cough US Shale cough) nations to "share the burden" and cut production (just as the Saudis warned yesterday).
Live Feed (via OPEC) - click image for feed
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It appears OPEC members have varying opinions...
- *KUWAIT'S OIL MINISTER SAYS HAPPY WITH OPEC OUTPUT DECISION
- *OPEC DECISION IS `VERY HAPPY' ONE: [SAUDI ARABIA] NAIMI
- *IRANIAN OIL MINISTER SAYS HE'S `NOT ANGRY' WITH OPEC DECISION
- #OPEC Venezuela Ramirez storms out red faced. Looked furious.
- *OPEC, NON-OPEC MUST SHARE OIL MKT BURDEN: NIGERIA MINISTER
- *OPEC `NOT PLAYING HARDBALL' IN OIL MARKET: NIGERIA MINISTER
- *OPEC DECISION WAS BEST THING TO DO AT THIS TIME: NIGERIA
- *OPEC MADE A GOOD DECISION: ECUADOR OIL MINISTER
- *WE ARE MAINTAINING OPEC UNITY: ECUADOR MINISTER
Maybe this is why...
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History may not repeat but it rhymes so loud sometimes that Einstein would be rolling in his repetitively insane grave. As Bloomberg notes, the last time that U.S. oil drillers got caught up in a price war orchestrated by Saudi Arabia, it ended badly for the Americans. "1986 was the big price collapse and the industry did not see it coming,” said Michael Lynch, president of Strategic Energy and Economic Research who has covered the oil sector for 37 years, "it put a lot of them out of business. You just don’t forget it. It’s part of the cultural memory." Think it can't happen again? Think again... consider how levered US Shale drillers are and just what Saudi has to gain from keeping their foot on the US neck... In 1986, the U.S. industry collapsed, triggering almost a quarter-century of production declines, and the Saudis regained their leading role in the world’s oil market.
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This is not good news for the US credit market...
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.
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And US energy stocks...
As Barclays notes,
As oil prices continue to fall, we review the likely supply response of tight oil supplies. Admittedly, cost of supply curves do not tell the whole story about where prices might bottom. At $80/b WTI, we think most producers will sweat it out and achieve their stated production objectives in 2015. But if prices remain at these levelsthrough 2015, it could compromise the significant potential new volumes that are needed to offset declines from existing wells. This new, higher-breakeven volume is small in 2015, but becomes much larger in 2016.
As we stated in the most recent Blue Drum, we expect a rebound in prices in 2H15. But, if prices do remain lower and fall to $70 for all of 2015, half of proven and probable (2P) remaining US tight oil reserves would be challenged. The near-term (6-month) effect would be marginal, but fewer new volumes would be added in 2H15 and in 2016. On a net basis, that implies a reduction to growth of about 100 kb/d for 2015 as a whole. A growth impact of 100 kb/d is a drop in the bucket in the context of total non-OPEC growth of around 1.5 mb/d. Thus, we expect downward price pressure to mount unless OPEC supplies less or demand rebounds.
At $70/bbl, 80% of the 2.8 mb/d of new tight oil volumes by 2017 (not including declines) would be produced (meaning 800 kb/d from new drilling, a reduction of 200 kb/d over the next three years), according to WoodMackenzie.
There are three reasons to be cautious with how cost curves are used.
First, WoodMac’s ‘half-cycle’ cost curve (above) represents new production only at a well, rather than at a project, level. Companies use ‘full-cycle’ economics (which include other expenses) to assess the economic viability of new drilling projects.
Second, cost curves do not address how existing production might react. For this, we turn to EIA’s Annual Energy Outlook. EIA scenarios which imply that if prices reach and stay at $70/bbl, annual growth of 630 kb/d by 2017 would be cut by 180 kb/d each year, net of declines.
Third, expected improvement in service costs will be another important determinant for the breakeven price of tight oil supplies. Oilfield services sector cost inflation has plateaued and stands to improve further in the coming years. This means that the cost curve in a year is likely to be up to $5/b lower on average. Permian D&C costs have declined from $9-10mn in 2012 to $5-7mn today.
OPEC producers have low production costs (in Saudi Arabia, even as low as $4/bbl), but will feel the heat fiscally. Still, tight oil producers are likely to be first affected in a low price environment.
Companies are likely to react very differently regarding their market capitalization, hedge ratio, and ‘oiliness’ of output. We estimate that small and mid-cap E&Ps(accounting for 880 kb/d oil and NGLs) would see earnings cut by 17% in 2015 at $80 and by 25% at $70/b, which would likely lead to a cut to capex and drilling plans in 2015. Adding production from infill drilling, drilling in new areas, and enhancing recovery rates from existing wells would add output but require different levels of capex. Wells already online would not be affected, in our view.
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So much for Saudi cooperation...
- *SAUDI'S NAIMI SAYS OPEC DOES NOT CUT OIL PRODUCTION
And now back to the old "plunging oil prices are good for the economy" spin cycle.