One month ago, Goldman spotted a curious divergence in the energy sector: whereas in 2015 and 2016, the energy-linked asset class that had the highest beta to crude and was the most impacted as a result of the plunge in oil prices, was debt and specifically junk bonds while equities were relatively resilient to crashing crude prices, in 2017 this relationship had flipped, and - as of mid-May - despite the latest tumble in oil prices, HY Energy credits had returned 2.3% vs. 3.3% for the broader HY index, while Energy equities were down a whopping 9.6%.
And while Goldman made some educated guesses for this abrupt shift in security sentiment, there still is no accepted widely reason for this striking divergence.
One month later, UBS'credit analyst Matthew Mish picked up where Goldman left off, and in a note "Oil bear market: is corporate credit mispriced?" finds that the answer is mostly yes. Just like Goldman, Mish looks at the energy market in 2015 vs. today to answer the key question: "How has US energy changed?" Below we summarize several of his key thoughts:
The health of the energy sector remains critical for corporate credit, directly accounting for 15% & 10% of US high yield and high grade debt outstanding. Average ratings for IG and HY energy indices have shifted less than one notch, but energy defaults have shifted credit quality higher. In comparison to early 2015, the proportion of triple C energy debt is roughly unchanged (11% vs 10%), there is roughly half the exposure to mid and low-single Bs (15% vs 31%) but almost triple the concentration in high single B debt (22% vs 8%). In addition, buoyant debt and equity capital markets have allowed a majority of energy firms to shore up near term liquidity.
But while it's no secret that energy is the most important component of the energy sector, a better question is how long can this decoupling continue, and at what price of oil will bond contagion finally reemerge.
According to UBS, the answer is $40/barrel and lower.
12 month WTI at or below $40 will elevate 2015-style risks for HY energy. We estimate a sharp or sustained decline in 12 month WTI below $40 or so (vs mid 40s current) will bring back non-linear downside risks for US HY energy. This is modestly below average breakeven oil prices for HY E&P firms. In addition, almost 30% of firms have only adequate liquidity and are dependent on external financing as hedges roll off.
UBS also highlights something we first noted over a year ago, namely that the recovery rate outlook remains weak due to elevated residual leverage and a greater proportion of secured funding. The Swiss bank calculates that in a $40 oil price scenario in 2018, net leverage would surpass 2016 levels for many global E&Ps, approach peak levels for some NA E&Ps, and approach or exceed prior levels for oily resource plays on average.
So now that the threshold bogey has been found, the next two key questions are why has credit been so resilient to weakness in oil and just as importantly, with volatility is rising, "what causes contagion?"
In answering how its rationalizez the resilience of credit in the face of lower oil, UBS lists three factors:
- First, risky assets correlate more closely with demand or currency-driven oil price changes. We estimate 85-90% of the current weakness is driven by supply.
- Second, financial conditions have also remained accommodative.
- Lastly, market illiquidity and ETF outperformance are pressuring managers to keep holding positions, as investors are not comfortable they can "buy the dip" in a modest selloff.
As for what causes contagion? UBS's response:
A demand-driven oil selloff that shakes confidence in the $50 – 55 consensus outlook, increasing default and downgrade risks or fund outflows that force ETFs and managers to raise cash from below average levels and reduce short-duration higher quality HY names.
Below we excerpt some more in depth thoughts from the UBS credit strategist:
"Brevity is the soul of wit" Shakespeares
Since late May the material weakness in crude oil prices has brought back a sense of déjà vu to corporate credit markets, particularly US high yield. In this note we attempt to analyze three pivotal questions for investors:
- first, how sensitive are US high grade and high yield credit markets to oil prices now versus the past?
- Second, what is priced into energy and ex-energy credit spreads, and how could credit spreads widen materially and trigger contagion concerns?
- And third, how should investors position portfolios?
Changes in credit market structure have materially impacted the future sensitivity of corporate credit markets to oil prices. Energy remains a large concentration in US HY and IG indices, directly accounting for c$150bn (15%) and c$500bn (10%) of debt outstanding, respectively (down from about 15-20% at peak levels). Average ratings for IG and HY energy indices have shifted less than one notch. However, energy defaults have been severe (in absolute terms and vs fallen angel downgrades), with trailing 12-mo defaults peaking above 25% (Figure 1). As such, the composition and mix of ratings within high yield energy have shifted notably. In comparison to early 2015, the proportion of triple C debt is roughly unchanged (11% vs 10%), there is roughly half the exposure to mid and low-single Bs (15% vs 31%) but almost triple the concentration in high single B debt (22% vs 8%, Figure 2). This is consistent with the number of 'weakest links' (those credits rated B- and below on negative outlook and most at risk of default) having declined by 35 – 40%.
There are a few additional salient points. First, while buoyant debt and equity capital market access have allowed a majority of energy firms to shore up near term liquidity, almost 30% of firms have only adequate liquidity and are dependent on external sources of financing, in part because hedges roll off (Figure 3). Second, should default risk rise for lower rated HY issuers, the recovery rate outlook remains weak due to the combination of elevated residual leverage and a greater proportion of secured funding. According to S&P, about 40% of all HY energy issuers, concentrated in lower rated names, will likely realize below (20%) or well below average recoveries (5%) in a stressed scenario (Figure 4). Third, historically HY energy spreads have been very sensitive when longer term oil prices decline below breakeven oil prices (Figures 5, 6).
Finally, we complement the macro analysis with micro perspective by illustrating sensitivity analysis on net leverage for a range of US IG and HY issuers (based on our equity analysts' estimates). Specifically, we illustrate net leverage by firm using 1) $40 crude prices back in Q1 '16, 2) current estimated leverage and 3) future leverage estimates based on $40 – 45 oil in 2017 and $35 – 45 oil in 2018. On average results are shown for global E&Ps (primarily crossover credits), North American E&Ps (predominantly high grade), and resource plays across basins (primarily high yield firms). In short, net leverage (Net debt/ EBITDX) is materially lower for global E&Ps (1.8x vs 3.1x), NA E&Ps (2.6x vs 6x), and resource plays (2.9x vs 4.3x) today versus in Q1 '16 when oil was near $40. In 2017 $40 oil would cause a material rise in net leverage for some issuers, but net leverage on average would still be significantly lower than one year ago.
However, if oil was $45 in 2018, this would cause a more pronounced increase in net leverage for many global E&Ps, NA E&Ps, and the multi-basin resource plays relative to current levels. In a $40 oil price scenario in 2018, this would cause net leverage to surpass 2016 levels for many global E&Ps, approach 2016 levels for some NA E&Ps, and approach or exceed peak levels for oily resource plays on average (Figure 7). Overall, we continue to believe the micro analysis complements our core view that the threshold for a more non-linear reaction in HY energy credit is at $40 or so in longer term oil prices.
Next, some views on the recent moves in the IG/HY markets:
Until the last week, the broader corporate credit market's reaction has been very muted outside of US high yield energy. US high yield energy spreads have widened by 118bp since mid-March (with oil down about $5), while US HY ex-energy spreads are 17 bp tighter, IG energy spreads are 1bp wider and IG ex-energy spreads are 9bp tighter (Figures 8, 9). The resilience in IG energy spreads, in part, reflects greater concentrations in gas pipelines, which are not directly impacted by lower oil prices, and mid triple B integrated and E&P issuers (which have some cushion against multi-notch downgrades to high yield).
Going back to the key divergence highlighted here, Mish explains that the weakness in HY energy spreads by rating is contained relative to prior years, specifically in lower grades (Figures 10, 11). Further, the resilience in US high yield energy contrasts sharply with falling equity prices and rising marketbased leverage (as proxied by HY median debt to capitalization, Figure 12).
How can traders rationalize the inelastic price performance? UBS answers:
First, we have previously argued that risky asset markets (e.g., global equity markets, industrial metals) correlate more closely with demand or currency-driven oil price changes. In this context, we estimate about 85-90% of the weakness in oil prices is driven by supply, not demand side factors (Figure 13). In recent months, the change in demand side factors has been negative, but currency-related factors have partially mitigated the overall impact. And financial conditions have remained fairly accommodative outside of corporate credit, so the reaction in markets has thus far been limited.
Second, while oil futures and option prices imply a material risk of oil prices at or below $40 through 2018 (Figure 14), we believe credit investors are taking a longer term view and assigning low probabilities to non-base case outcomes given market illiquidity does not allow clients to exit and re-enter positions in times of stress. What could trigger more forced selling? From a narrow perspective, rating downgrades, defaults and fund outflows are three potential triggers. Downgrades (and defaults) are increasingly probable for lower quality HY firms if oil prices stay in the low $40s or head lower. But with the rating agencies pricing in $50 – 55 oil in coming years, it will take a more material shift in sentiment to or below $40 heading into 2018 to trigger material revisions. Further, while we recently started to see material outflows (e.g., c$1.5bn in HY ETF outflows since Wednesday) with lower oil prices, in general, the outflows have been modest in recent months. And similarly HY bond markets, while less active in recent days, have been resilient at lower levels of activity.
Finally, here is why $40 oil is so critical:
"If oil prices fall to $40 or below, the negative impact on rest of world profits (via commodity-related foreign subsidiaries of US companies) could be a material headwind for aggregate corporate profits, and a prolonged $40 oil price would trigger more stress and defaults in lower-quality HY issuers heading into 2018 (and could prompt banks to tighten lending standards on C&I loans at the margin). While lower oil prices should limit upside inflation risks, market expectations for Fed rate hikes are already well below the median path projected by the Fed, suggesting the market is priced for a dovish outcome already. A supply-driven drop in oil prices coupled with resilient equity markets and financial conditions could still have the Fed tighten policy more than the market expects."
Which is also why $40 oil may be the level at which the Fed officially throws in the towel on further tightening (even though as Dudley explained earlier today there has been no tightening), and starts jawboning the arrival of the next easing cycle.