A month ago, I wrote a piece on zero rates, resource misallocation, and shale oil that warned of the potential negative impact that low oil prices could have on the funding for shale drillers and the potential contagion this drying up in funding could have in risk markets like high yield bonds. My conclusion was that the energy high yield market was one to watch, but that an ugly scenario was not yet upon us. In the month since I wrote that piece, the scenario has become somewhat more negative and I want to explain what I think is happening in oil markets and how it is related to both the US economy and US high yield.
First, let me say that when I wrote the shale piece, we were in the midst of some market volatility that saw both oil and share prices declining precipitously. The day after I wrote the post, I felt it had an alarmist quality to it in view of my upbeat opinion about the state of the US economy. So I wrote a piece to outline why we were not yet in a global financial crisis. I believe the US economy is beyond stall speed right now, meaning it cannot be derailed and lapse into recession because of one exogenous shock like the decline in oil prices. Moreover, the decline in oil price is a boost to consumer disposable income that can bolster the economy. We should also remember that the US economy is both large and relatively closed i.e. trade makes up a small percentage of a large output so that disturbances from abroad are small in relative terms to the US domestic economy. So, on the whole, I expect the US economy to continue to outperform. However, I do see only 2%ish growth for the US because wage growth has yet to kick in, while household balance sheets are still stretched. A domestic disturbance like one centered around shale oil, that could create financial market contagion, might be more potent, especially if it brings with it a real economy effect in terms of capex and jobs.
Now, the story on oil starts with the Saudis. Despite rumours that Saudi Arabia has a political agenda in its oil pricing decisions, following Occam’s Razor, an analyst would note the precipitous drop in Saudi market share, making it the likely reason for Saudi Arabia’s price moves. Last week, John Kemp wrote an insightful piece showing why this is so. Let me quote from his article here:
Saudi Aramco cut the price of December crude deliveries to U.S. refiners on Monday in order to protect its competitiveness amid an erosion of its U.S. market share by rival exporters such as Canada and Iraq.
In August, U.S. crude imports from Saudi Arabia slipped below 900,000 barrels per day, according to the U.S. Energy Information Administration.
With the exception of a brief period in 2009 and early 2010, Saudi exports to the United States fell to the lowest level since 1988 (link.reuters.com/jez33w).
U.S. imports from Saudi Arabia in August were just 70 percent of the average level for the past ten years which has been around 1.3 million barrels per day.
Saudi oil, which is priced at a differential to a U.S. sour crude marker, had become too expensive compared with alternatives available to U.S. refiners.
So Saudi Aramco has been forced to cut the differentials for U.S. refiners by between 45 and 50 cents (depending on grade) per barrel even as it raised differentials for refiners in Europe and Asia.
RIVAL EXPORTERS
Some commentators have interpreted the U.S. price cuts as a signal the kingdom is initiating a deliberate price-war targeting U.S. shale producers. The reality is more complex.
Most Saudi exports to the United States are much heavier and certainly sourer than the light sweet oils being produced from shale formations like North Dakota’s Bakken and Texas’ Eagle Ford.
Aramco has therefore been spared head-to-head competition from rising U.S. shale output, which has mostly fallen on U.S. imports from West Africa.
However, the company’s market share over the summer was hit by competition from Iraq, Venezuela, Brazil and Canada, so Aramco has cut its prices in the region to stabilize sales and buy back some of its lost share.
This is a story of a business enterprise, Saudi Aramco, making a business decision to cut price in order to win back market share. Moreover, Kemp also reminds us that the Saudis actually increased prices to European and Asian customers while cutting to US customers, telling us that the problem is localized.
Even so, regardless of whether the Saudis have political motives, the outcome is the same for US crude producers. It means greater competition. And the 25% drop in prices is killing margins. As I wrote last week regarding Saudi maneuvering, different producers face different breakeven levels. “EOG Resources says it can survive at $40 based on its drilling costs at Eagle Ford. But, according to ITG Investment Research, Cana Woodford producers in Oklahoma need $100 to breakeven and the Anadarko formation in Texas and Oklahoma has a breakeven around present prices of $79 a barrel. ITG says Bakken and Permian producers can make it at $14-16 less.” But we are already at price levels that will bite and the capex implications are mounting.
For example, yesterday Transocean, a deepwater driller, warned of a “cyclical downturn” not just a blip in the market. On Friday it had written off $2.79 billion in goodwill. And Monday it warned of more writedowns to come. While Transocean talked a good game, the reality is that they reported a $2.22 billion loss for the quarter and their stock is down 45% in the past year. The key to note from the FT’s coverage of this is the following:
Offshore oil has some of the highest production costs of all oil deposits, particularly in deepwater developments in the seas around countries including Angola, Brazil, Norway and the UK.Rising costs have squeezed oil companies’ margins, forcing them to cancel some projects and delay others to look for cheaper solutions, even before the latest plunge in crude.
Mr Newman said the fall in the oil price could “temporarily exacerbate” the oversupply of offshore rigs, putting further downward pressure on the rates Transocean can charge. The price drop might also hit utilisation of the group’s rigs, with more idle time between contracts.
Capex is already turning down for deepwater drillers.
Then there is the oil sands in Canada. In a mostly bullish article about the potential for oil sands revenue to reach $2.5 trillion by 2038, the Financial Post writes the following:
The research organization wanted to present the most conservative oil price scenario that would still enable projects to go ahead, said Peter Howard, president and CEO of CERI.
“At $85, we are still seeing significant benefits across the board,” he said. “But when you drop below that, if you drop below $80, you would actually start affecting developments, they would get pushed off and maybe cancelled.”
That is a clear sign that Canadian oil sands producers are starting to feel some pain at these prices just below $80 a barrel. So it’s not just frackers that get affected by these low prices, it is deepwater and oil sands as well.
And the fall in oil prices is already hitting the funding market, which I find worrisome since this is the scenario I warned of last month. The FT writes:
The shale boom that has created a surge in US oil and gas production has been financed in part through a steep increase in sales of low-rated debt in the past decade. Energy bonds now account for 15.7 per cent of the $1.3tn junk bond market, according to Barclays data, having accounted for just 4.3 per cent of that market in 2004. “No one can avoid the energy sector,” said Sabur Moini, a high-yield fund manager at Payden & Rygel. “Every high-yield manager has a lot of energy bonds.”
Junk bond investors are now facing a double blow. A further drop in oil prices could put pressure on the highly indebted companies in the sector and potentially trigger a wave of debt restructurings, which has not been seen since the depths of the financial crisis.
The second risk is the extent of the sell-off for junk-rated energy bonds. The bonds have been the worst performing group in the market for high-yield corporate debt, with negative returns of 1.3 per cent in the past month, according to Barclays indices.
A further drop in bond prices raises the odds of a broader spill-off at a time when trading volatility has increased in riskier assets. “Energy was considered a fairly defensive sector and the whole renaissance of US shale made it a good story,” said Mr Moini. “Now everybody is paying very close attention to what may happen to some of those companies if conditions become truly unfriendly.”
Junk bond managers are also mindful that the Federal Reserve is no longer providing a tailwind for asset prices as the central bank has wrapped up its large-scale bond purchases.
Fed policy helped drive global investors into the riskiest corners of the US debt capital markets, and investors are primed for selling down their portfolios should interest rates normalise in the coming months. The drop in prices has pushed yields to 6.9 per cent at the start of the month, the highest level since July 2013, according to Barclays.
The interconnections here then suggest that the fall in oil prices will significantly impact capex. CERI President Howard admitted that oil sands projects in Canada will be cancelled at these levels. And Transocean has told us that deepwater drilling rig count has already been significantly affected. To the degree funding costs rise here, breakevens in oil will also rise. We could even reach a tipping point where the rise in breakevens from the rise in funding costs causes a further rise in yields, creating yet higher breakevens for drillers. Warren Mosler believes the lower capex could even materially affect national income and product accounts for the US, causing a negative print for Q4. I don’t think we are there. However, the situation is growing more alarming daily. And my sense is that $75-80 is a sort of tipping point, below which ugly scenarios take form quite rapidly in high yield energy funding markets. The spillover into the broader high yield market is a certainty in this scenario.
For me, there are a number of takeaways here. However, the principal takeaway from the shale oil boom is that interest rate policy does have a tremendous effect on capital investment. The shale oil boom is not just the result of high oil prices, it is also the result of higherIRRs due to lower discount rates. But, in a world of low rates, risk asset decouple from safe assets during periods of volatility. Keeping rates at zero is no guarantee for the risk seeking return crowd. Expect a rush to the exits if and when a real crisis comes. Not every one will make it out alive.