We have also written about the percentage of junk bonds tied to the U.S. fracking business hovering near 16% of the junk bond benchmark index, an unusually high number, up from only 7%
a few years back.
Many of these bonds are tied to smaller high cost producers dependent on high oil prices to bail them out and make a profit. Now that oil prices seemed to have gone south with the seasonal migrating birds, it's anyone's guess how many of these firms will be around should oil prices stay down or go lower.
Back in the dot.com days tech stocks made up 30% or more of the S&P 500. Check out what percent that sector occupies of the index today. Not a prediction, just a note even though we all know past is not always prologue.
For more on the hydrocarbon meme and what might happen, here's a good read from Marc to Market.
Oil Market Meets Minsky
During the Great Financial Crisis, Hyman Minsky, was rediscovered.
Minsky's insight was that long periods of steadily rising asset prices
encourages financial engineering and leveraged bets that assume a
continued rise in asset prices. The so-called Minsky moment comes when
the asset prices stop rising and even fall. The virtuous cycle turns
vicious.
We are now all familiar with how that narrative played out in the housing markets in numerous countries. The question we pose is whether similar forces are unfolding in the oil market.
For the past several years, oil prices have averaged the highest on
record, even though the 2008 peak near $150 has not been approached.
The high price of oil did two thing. First, it helped create a mindset
that was predisposed to believe we were at peak oil. That new finds
were rare and located in more difficult places to reach. Second, it
helped spur technological advances, and encouraged new production.
The idea that oil prices were going to continue to trend higher for
as far as the eye could see became extremely entrenched, and not just in
the oil market. This was the basis for both conservation and
development of alternatives. Some $90 bln of high yield debt was
issued by US energy producers over the past three years. This
effectively doubled the energy sector's share of the high yield bond
market. The ability of borrow was predicated on the value of the oil in
the ground. In addition to the high yield bonds, many banks have
provided leveraged loans to the shale producers.
The leveraged aspect is not limited to the shale producers, but downstream and upstream concerns were also leveraged.
This includes the borrowing of money for railroad cars to ship the
oil. It include the chemicals and other supplies needed for the
fracking.
The precipitous decline in oil prices changes this dynamic.
Many observers seem to be repeating the judgmental mistakes made in
late-2007 and early 2008, and not giving enough due to Minsky's
insight. The key is not so much the level of oil prices, but that fact
that prices are not rising. Rising prices was what justified the
leverage and capital expenditures.
The high yield shale sector energy bonds are likely held in by asset managers and hedge funds.
It would not be surprising if some pension funds, endowments and other
funds had exposure through their alternative investment allocations,
after all, like the housing market, Peak Oil was as story of a life
time. The high yielding energy bonds are off around 13% over the past
5-6 months. The industry indices that track the sector are off about
2.5% excluding energy. According to some reports that track fund
flows, some $14.2 bln has left high yield funds this year after taking
in around $72 bln over the past five years.
The implication of these developments is that the days of cheap credit to energy sector broadly conceived is over.
This will curtail exploration and new development. Capacity that has
already been funded will come on stream in the coming months, but new
production will be slower coming on line. An industry report cited by
Reuters found that permits for drilling new wells, which had doubled in
the past year, fell 15% in the month of October (i.e. before the latest
leg down in oil prices).
This is a turning point in the industry. The shale sector is
fragmented. Its debt acts as a high fixed cost. These conditions will
produce a behavior response similar to what we have seen in other
industries when faced with a similar situation. First, high fixed costs
relative to variable costs provide incentives to initially produce even
at a loss. This only aggravates supply driving the decline in prices.
Second, as the high yield bonds and leverage loans become distressed,
more provisions will have to be made by the banks, while fund managers
will look to reduce exposures. Third, there will be industry
consolidation. This appears to have already begun with the
Halliburton-Baker Hughes tie up and Berkshire Hathaway's purchases in
the fracking fluids and chemical space.
The Peak oil story filtered through many other sectors outside of energy.
High costs for energy encouraged conservation, but as oil prices led to
lower gasoline prices, this has changed. In fact, SUVs and light truck
sales helped fuel strong vehicle sales this year. Data out yesterday
indicated that November was the second month since 2006, that Americans
bought more than 17 mln vehicles on a seasonally adjusted basis. August
was the other month.
Last month luxury SUV sales soared. Purchases of the Cadillac
Escalade and the Lincoln Navigator increased by about 90%.
Incidentally, these models are both less energy efficient and higher
profit margin (~$10k pre-tax profit per vehicle, according to industry
analysts cited by news wires) than smaller vehicles).
Two reasons and both have to do with human behavior: For dealers, bigger profit margins. And for all those soccer moms tooling around the country, power and safety.
When given a choice, power and safety trumps fuel efficiency every time.
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