Now that the defaults and bankruptcies have begun, and now that David Einhorn has jumped on the bandwagon (coining a new word in the process), it’s time for banks to start taking a hard look at just how bad the fallout will be once hedges start rolling off and more weak hands are shaken out of the HY oil & gas space.
As we discussed at the beginning of last month, the “revolver raids” have already begun for some heavily indebted US shale companies who were set to see their credit lines cut after banks performed their bi-annual review in April, which is based on where crude has traded over the preceding 12 months. Those credit lines will be assessed again in October and according to a UBS survey of the banks who have helped finance the oil & gas industry, the outlook is not good, with nearly two-thirds of respondents indicating that loan quality is likely to deteriorate. No one said they expected conditions to improve and more than 80% of banks reported tightening credit lines to oil & gas companies.
For its part, UBS believes the “rubber will meet the road” for the HY energy in H2 as energy prices likely will not be high enough to support “lower quality” players.
HY Energy Spreads have continued to tighten over the last few weeks, with overall energy sector spreads now trading at 611bps, E&P spreads at 688bps, and servicers at 682bps, versus the HY Index at 477bps. This compares with 661bp, 765bp, and 731bp respectively as of 4/22. The outlook from lenders is likely painting a more realistic picture on the state of conditions. As part of the Q1 2015 Fed Senior Loan Officer Survey, special questions were asked to banks who provide financing to firms involved in the oil and natural gas sectors. Specifically, banks were asked to project their outlook for delinquencies and charge-offs assuming both 1) economic activity moves in line with consensus and 2) energy prices evolve as priced via the futures curve. Despite Q1 economic forecasts being optimistic and Q1 commodity prices having stabilized, 60% of banks expected loan quality to deteriorate, while the remainder expected loan quality to remain stable. Virtually no banks expected an improvement in loan quality…
We believe the rubber will hit the road later this year for HY Energy. The recent rally in oil prices is insufficient for lower-quality energy firms who have most of 2016 production unhedged. Not to be forgotten for many E&Ps, natural gas prices are still struggling, and haven’t enjoyed the same bounce as oil prices YTD (Figure 3). Banks may not have cut reserve bank lending facilities aggressively yet, but the October review may be less forgiving with this backdrop.
In addition, the current spot price of WTI ($59) is well above the UBS 2015 YE forecast of $51, based on demand/supply fundamentals.
UBS also discusses one of our favorite topics: the idea that access to capital markets — thanks largely to the Fed-induced quest for yield and concomitant ultra-low borrowing costs — have allowed otherwise insolvent producers to keep right on drilling, contributing to oversupply and, ironically to their own demise.
Energy has been an outperformer in 2015 and open capital markets are to thank. Oil & Gas Issuance in HY Energy has been $17.5bn YTD, or 12.4% of total issuance. This is below the average 15-16% of the prior four years, but much of this year’s drop occurred in January, while issuance for the rest of 2015 has been closer to historical averages of prior years. Our equity colleagues have also cited $`11bn of E&P equity issuance YTD as of April 27th, and that channel remains open.
Unfettered market access only serves to delay the inevitable, as proven this week when American Eagle Energy — who pulled a Movie Gallery in early March after failing to make even a single coupon payment —became the fourth casualty of the oil downturn, after filing for Chapter 11 on Monday. As we said last month, expect many more to come as the countdown to the day of reckoning for the US shale sector has just about run out.