With oil prices pushing cycle lows and Shale firms as loaded with debt as they have ever been, the spike in energy sector credit risk should come as no surprise as the hopes of the last few months are destroyed. At 1076bps, credit risk for the energy sector has never been higher. As UBS recently warned, more defaults are looming and, as we discussed this week, private equity is waiting to pick up the heavily discounted pieces.
Where are the defaults? They're coming: we've seen Quicksilver Resources and Dune Energy, are likely to see American Eagle Energy, RAAM Global Energy, Venoco and thereafter perhaps Connacher Oil & Gas, Samson and Sabine Oil & Gas. Most E&P firms had hedges in place for 2015; defaults typically lag by about 12 months and the clock started ticking late last year.
We’ve talked a lot lately about HY in general and about the HY energy space more specifically. Recapping, periods of QE in the US saw US HY supply surge 50% above normal levels as issuers sought to take advantage of lower borrowing costs and investors clamored for the relatively higher yields they could get by taking on more credit risk. More recently, struggling oil producers have tapped the market in an effort to stave off insolvency as crude prices plummet, leading directly to a situation where outstanding HY energy bonds account for a disproportionate share of all outstanding debt in the space. With rates set to rise later this year, with crude prices likely to stay depressed for the foreseeable future, and with suppressed liquidity in the secondary market for corporate credit poised to bring heightened volatility, the stage may be set for a high yield meltdown.
However, what is potentially more worrying is a broader-based default cycle... driven by credit contagion, as UBS explains why commodity defaults could spread
In the wake of the commodity price swoon one of the recurring questions is will the stress in commodity markets spillover to other sectors?
First, regular readers will recall our HY energy default forecast of 10-15% through mid- 2016. Simply framed, the commodity related industries total 22.8% of the overall HY market index on a par-weighted basis. In our view, sectors most at-risk for defaults (defined as failure to pay, bankruptcy and distressed restructurings) total 18.2% of the index and include the oil/gas producer (10.6%), metals/mining (4.7%), and oil service/equipment (2.9%) industries.
How large are contagion risks to the broader HY market? And what are the transmission channels? Historically, investors in the limited contagion camp would probably point to the early 1980s. In this cycle commodity price defaults spiked with the drop in oil prices yet average default rates (IG & HY) increased only moderately amidst a favorable economic environment. In our view, however, the parallels in terms of the credit and asset price cycles are a stretch versus the current context. In the last three cycles, commodity price defaults have either led or coincided with a broader rise in corporate default rates (Figure 2).
But why should there be contagion from commodity sectors to other segments?
There is a clear pattern of default correlation dependent on fluctuations in national or international economic trends. Commodity price weakness is symptomatic of weak economic growth in China and emerging markets – with possible spillover risks for commodity related sovereigns (oil exporters) and corporates.
In addition, distress in one sector affects the perceived creditworthiness as well as profits and investment of related firms in the production process. For example, exploration and production firm defaults could negatively affect suppliers and customers which would include oil equipment and service, metals, pipeline, infrastructure, and engineering firms. Furthermore, related literature points to the significance of the supply/demand balance for distressed debt; our theory is that there is a relatively finite pool of capital for distressed assets, implying greater supply of distressed paper pushes down valuations of like assets. Unfortunately, a rise in the supply of stressed bonds typically coincides with a decline in demand for such assets. This self-reinforcing dynamic historically leads to a re-pricing in lower quality segments.
But hope springs eternal in greater fool stock land...