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Oil Prices

Posted by Jeremy Merchant on Oct 1, 2015 4:00:00 PM
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Since the summer of 2014, the drop in crude has been somewhat dramatic. Today, we find that crude is trading somewhere between $40-$50 per barrel. This price drop has been a significant reduction from historical prices that have averaged around $75+ per barrel, from 2011 through mid-2014.

During this same time frame, capital expenditures to expand oil production grew exponentially. Oil companies have increased their debt from roughly $1 trillion in 2006 to around $3 trillion in 2014. This capital (raised by oil companies) has come in the form of syndicated bank loans (loans from multiple banks called a syndicate) as well as from the bond market.

According to the Bank for International Settlements, oil and gas companies increased their debt via the bond market at an annual rate of 15% per year from 2006 ($455 billion) to 2014 ($1.4 trillion). In addition, syndicated bank loans increased at an annual rate of 13% to $1.6 trillion.

In total, the debt issued by the energy sector accounts for approximately 15% of the debt market. Due to the technological advancements in drilling commonly referred to as "fracking", capital flows to this sector have been enormous. In addition, some of this money has been speculative in nature with higher leverage and a less than robust credit profile known as high-yield debt.  

Over the past 20 years, the energy sector has made up approximately 5%-15% of the high-yield market. Today, that figure is approximately 14%. Historically, the energy sector has been considered a defensive sector within the high-yield market. In fact, the average default rate for the energy sector over the past 20 years was 1.4% compared to the market average of 3.1%. However, when the price of oil drops dramatically, as it has done 21 times since 1859, the default rate naturally increases substantially.

According to an analysis by the Leuthold Group, there have been eight modern era oil price crashes of 40% or more. The two oil price collapses in the second half of the 1980s most closely resemble that of the current oil price collapse. These oil price crashes were the result of an oversupplied market rather than a reduction of demand due to a recession. During the 1980s, the increase in supply came from Non-OPEC countries (non-US). In the current case, U.S. shale producers have been the driving force behind the increased supply. However, in every case, OPEC has chosen to pursue a strategy of maintaining market share instead of supporting oil prices which has resulted in a price collapse.

Oil_Prices_Graphic

As a result of these dramatic oil price drops in concert with the increased leverage we noted above, we expect the energy sector to remain under pressure - especially those that financed their operations in the high-yield market. The natural progression for firms under financial stress is to sell assets. However, these firms will also be inclined to maintain or even increase production to remain liquid and meet interest payments. This additional production will sustain the supply/demand imbalance for longer than expected and amplify the oil price decline.

JP Morgan recently estimated the default rates of the high-yield energy sector with oil at $50 per barrel. They estimated that defaults could reach 3.9%, 4.3%, and 19.7% in 2015, 2016, and 2017, respectively. In general, high-yield bonds currently have an overall default rate of 2.2%, according to Moody's Investor Service. Looking forward, Moody's expects the overall high-yield default rates to move up to 3% in 2016, which is largely due to energy sector defaults.

Overall, the drastic drop in energy prices should be a benefit to overall economic activity. Employment in the oil and gas sector comprises only 0.5% of total U.S. employment and only represents 2% of U.S. GDP. However, consumers which account for 70% of U.S. economic activity, will reap the benefits of lower gasoline and energy costs. The Energy Information Administration estimates that households may have an additional $700 to spend this year due to lower gasoline prices. This may not seem material initially, but in aggregate it is substantial.

While the general ripple effects of lower energy prices are positive for the overall economy, within the high-yield bond market lower energy prices might cause future volatility. Understanding the translation of how market dynamics might impact asset classes is something our Investment Policy Committee (IPC) is always studying.

Looking forward, our IPC believes that a proactive reduction in the portfolios' high-yield bond exposure is now warranted. Expect us to reduce our high-yield exposure within the portfolios in early October.

 

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security. 

Topics: Investment Updates