Back in March, when oil was aggressively rising from its February lows and the market was happily extrapolating a rebound to more traditional levels, around $60-70bbl on hopes of a supply reduction from OPEC, we showed a dramatic chart of the energy sector's forward PE, which had risen to never before seen levels.
Since then oil has plateaued and has resumed its descent, recently sliding in a new bear market, and as of this moment flirting with $40/bbl as the realization of an unprecedented gasoline glut, together with ongoing excess supply and weaker than expected demand, pushed back the supposed "equilibrium" date from late 2016 to sometime in 2017 if not later.
But while oil has seen a steep pullback, this has not yet impacted junk bonds which have been surprisingly resilient on the back of the ECB's launch of the CSPP program in June at which point the oil-HY correlation broke down, nor has it truly hit energy stocks.
That may change soon: as BofA's Michael Hartnett writes, "traders should wait to see if oil can hold $40/bbl before adding risk here. Should oil slice through $40/bbl, attention will quickly switch to weak oil, weak Chinese renminbi and weak credit in a repeat of last summer. EM debt could also be pressured given the massive recent inflows into the asset class. Note that energy stocks have jumped far higher than EPS expectations would justify."
How much higher? One answer is shown in the following chart from BofA, perhaps inspired by the fwd PE valuation chart we showed 5 months ago. A rough indication suggests that unless oil manages to credibly rebound and sustain its bounce, energy companies appear to be overpriced about 100% relative to fundamentals.
While the market continues to generously give energy companies the benefit of the doubt, a new problem has emerged: a rapidly rising cash burn rate. As Bloomberg points out, free cash flow after capital expenditure has collapsed and shows little sign of improving.
Worse, as of this moment only Exxon's free cash flow is positive, and even then only just. What's more, even Exxon's free cash flow dips sharply into the red once factoring in the thing that really counts for investors: paying dividends.
It used to be that companies would lever up to do buybacks. Now they are issuing debt just to pay dividends. Nowhere is this more obvious than in the following chart showing the substantial increase in energy sector leverage over just the past 12 months.
As Bloomberg concludes, "leverage has jumped, yet remains manageable for now. But the faltering oil-price recovery and a persistent glut in inventories are keeping the pressure on. Moreover, while oilfield services contractors have taken a lot of the strain so far by cutting fees, they are at a breaking point. Big Oil shouldn't expect the third and fourth quarters to be keepers, either."
Unless central banks can manage to push the price of oil materially higher in the coming quarters, the energy sector is likely to see a sharp equity repricing in the coming months... assuming of course that central banks don't step in and bid up energy stocks. These days, that is a very foolish assumption.