In late 2015 and early 2016, as oil crashed, a curious divergence emerged: as crude was dropping, junk bonds crashed with a far greater beta to the drop in the underlying commodity than equities, which remained persistently sticky, stubbornly refusing to drop to a "fair value" implied by oil. The same phenomenon was even more obvious on the way up, as once oil had found a "bottom" energy stocks surged, at times approaching record forward P/E multiples. We showed this epic divergence one years ago in "There Is No Word To Describe This" - The Energy Forward P/E Multiple Is Now Off The Charts."
There was a simple explanation: markets assumed that last year's oil crash was an outlier event, and as a result projected that oil would quickly return to its pre-crash levels.
It tried, and despite OPEC throwing everything it had ad it, it failed.
Which brings us to an interest observation made by Goldman overnight: in 2017, the relationship noted above has been flipped, and this time around it is HY Energy that is resisting lower crude, even as stocks are sliding far more than the recent drop in oil would suggest. Here's Goldman:
Spot crude prices have declined by over 12% since their peak on April 11, touching levels last seen prior to the OPEC’s decision to cut production in November. The sell-off has been even more pronounced for longer-dated contracts (on a beta-adjusted basis), reflecting increasing concerns over future balances in 2018 and beyond. In the HY market, the Energy sector has again outperformed its beta to crude over the past few weeks, a pattern that is reminiscent of previous oil sell-off episodes in the second half of 2016 and early 2017 (Exhibit 3).
This outperformance also contrasts with the sharp underperformance of Energy equities since the beginning of the year (Exhibit 4).
Putting things in context, Goldman notes that HY Energy credits have returned 2.3% year to date vs. 3.3% for the broader HY index, while Energy equities are down 9.6% vs. a positive price return of 6.8% for the S&P 500.
Our commodities team views the recent weakness in long-dated forwards as a reinforcing factor to their positive near-term view. As they put it, long-term surpluses create near-term shortages as more downside pressure on long-dated prices will likely be offset by more upside pressures on near-dated prices. For oil, their baseline case for the next three months remains a decline to $50/bbl for long-dated WTI contracts (for context, the five-year contract is at 51.6$/bbl currently) and an increase to $55/bbl for spot prices vs. $47.8 currently.
So why have energy junk bonds shown so much more resiliency than equities in 2017, unlike a year ago? Again, Goldman believes it has an answer: "We think the much stronger resilience of Energy credits both vs. their own recent history and vs. their equities counterparts reflects three key factors."
- First, the interaction between the trajectories of the spot and long-dated oil prices has been more damaging for equities relative to credit. For equity investors, the sharp decline in long-dated prices suggests the outlook for future earnings may have turned more challenging, causing a downgrade of the sector’s valuation . For bond investors, the focus remains more on production costs and efficiency gains, both of which have dramatically improved over the past few quarters. Based on 2016 data, our Credit Research Team estimates the cost breakeven level for their E&P coverage universe at $56/bbl vs. $68/bbl in 2015, a sizeable decline that highlights the magnitude of the efficiency gains since the onset of the New Oil Order, especially for shale producers.
- Second, credit quality for HY Energy issuers has improved over the past few quarters. Defaults have slowed down materially while the share of CCC-rated Energy bonds declined to levels that are in-line with historical norms (Exhibits 5 and 6).
- Finally, refinancing risk is quite low while funding markets remain accessible for Energy issuers (Exhibits 7 and 8)
Finally, there is China, and the fact that the recent crash in Chinese commodities has so far failed to spillover to either the Yuan or broader Emerging Markets. A reason for this, as UBS showed previously, is the far lower vol of the USDNY, which in turn has been driven by the near shuttering of the Chinese capital account window, and the PBOC's halt of capital outflows (more on that shortly), in big part facilitiated by the return of the Chinese housing bubble, which after a few scary months at the start of 2017 is growing once again.