On Wednesday, you saw what the annual Windsor gathering of energy executives, ministers, and ambassadors agreed on was the most important “shifts” in the energy sector today.
But one topic got more attention during my briefing than any other.
And I wasn’t the only one talking about it, either. You see, there’s a crisis brewing…
In fact, we might be looking at something similar to the Credit Crunch of 2008. That’s what has so many global energy insiders worried.
But don’t worry, because this time, you’ll be prepared.
In fact, you’ll even be able to play it for some gains…
The Days of Easy Energy Credit are Over
There were a number of interesting discussions during our three days at Windsor Castle. One involved the currently accelerating energy debt crisis. In fact, it was one of the main points in my briefings and was reflected in the presentations of others.
The bottom line is simply this.
Regardless of where the crude oil price moves from here, there is little likelihood that any rise in the level will be large (or happen soon) enough to save most companies mired in a vicious cycle of ever more debt.
Now, much of this we have discussed here in Oil & Energy Investor on several previous occasions.
For some time, most American oil & gas producers have operated cash-poor. When prices were $80 a barrel or more, it made sense to reserve revenues for dividends, stock buybacks, and so on. Actual forward working capital was instead covered by lines of credit, obtainable at easy rates from eager banks.
Not these days.
The problem is now beyond acute. I discussed this matter at the annual Windsor Energy Consultations last weekend, and today I want to share some slides from my presentation with you to drive the point home.
Sometimes pictures provide a stark indication of that is going on.
Oil Prices Recovery is Too Little, Too Late for Many Companies
You see, even with oil recovering of late – WTI, the Benchmark crude rate set in New York is up 47.69% over the last month – prices are still way too low for companies to make enough revenue to make ends meet. Instead, producers increasingly rely on debt. As credit increases and net cash flows (that is, operating cash minus interest payments and capital expenditures) decline, a significant and expanding gap has emerged.
This chart, from my Windsor presentation, shows as much:
As you can see, energy debt is rising even as net cash flows are decreasing. The situation is rapidly getting worse, and the result is increasing dependence on high-yield bonds.
You may know them as “junk bonds.” This next chart shows the rising dependence on them:
These “junk” bonds are well below investment grade, and oil and natural gas companies are the fastest rising users of these instruments. From about 15% of the market less than a year ago, they now occupy almost 35%.
This could be sustainable, if not for one thing.
Investors can see the writing on the wall, and are increasingly asking for higher and higher yields on bonds, as measured by the “spread.”
The “spread” is just the difference in yield between a given bond and the comparable risk-free Treasury bonds (these are considered “safe” because they default only if the Federal government does). Widening spreads mean investors are pricing in more risk for the energy sector and require a higher yield as compensation for that risk.
And spreads have been expanding rapidly:
At rates approaching 16%, spreads on energy bonds are now worse than the spreads of the riskiest high yield bonds at the height of the credit crunch in 2008-2009.
And remember, these spreads just show the difference in yield between energy bonds and Treasury bonds. That means that at spreads reaching 16%, the overall cost to the company using these bonds is actually about 19%, as this next slide shows:
Yields at those levels, in an industry that is making less money than it has in years, are unsustainable. It will clearly result in a rise of bankruptcies, among both publically traded and private companies.
In fact, this process has already begun, as this graph of energy bankruptcies shows:
What you see here is a disturbing cycle emerging.
When prices fell and stayed low, oil and gas companies were forced to increasingly rely on the junk bond market for their capital needs.
That pushed yields on energy bonds higher, even as access to cash for these companies was drying up.
The risk that the energy companies will default on these bonds, then, is higher than it has in a long time. Which means that even the healthy companies that could use some credit can’t afford it, because the yields have been driven up to record levels by the rest of the industry.
There will be three consequences…
- A Rise in Bankruptcies (and Great Assets on the Cheap)
First, more companies will go insolvent, bankruptcies will rise, and a round of intense “creative destruction” will ensue. But remember: bankruptcy cancels only the company’s debt load.
The company’s assets, on the other hand, still have market value. And in the case of those in oil and natural gas, these assets extend well beyond equipment to fields, land leases, production contracts, infrastructure, and oil and gas volume already out of the ground, among others.
You’ll be seeing an interesting sub-market forming here, in which surviving companies will be able to acquire very desirable assets (and the revenue that goes with them) at a discount.
For you, that will mean some real opportunities to invest in companies that will rapidly expand their market share.
- Lower Production (Bringing Higher Oil Prices)
Second, many of the companies currently running on fumes (or, if you wish, just one step ahead of the sheriff) are frantically producing oil and gas to stave off financial collapse. That has added supply to a market already in a glut, adding to the problem.
When the debt burden of these companies finally catches up to them, we’re likely to see the removal of this “desperation production,” and along with it one of the factors keeping oil prices down.
Now, this last effect of the debt crisis is more concerning globally than the other two. I got more questions on this one matter than on any other part of my briefings, often leading to extensive “side bar” conversations over coffee (or something stronger).
- Debt Crisis Spreading Globally (Giving You Short-Term Opportunities)
Third, oil and natural gas sales worldwide are denominated in U.S. dollars. Because of this, a wide range of assets related to energy are also held in dollars around the world.
So as defaults in dollar-denominated energy debt rise, we’ll see the value of a lot of other dollar-denominated holdings fall. If that reminds you of the credit crunch experienced in the mortgage melt down of a few years ago, it should.
Back then, bad debt in the U.S. resulted in waves of value destruction for assets retained in other locations. Yet, the potential for damage this time around may even be worse the longer the energy picture remains negative.
The reason is simple.
Energy holds a much more central position in economies worldwide than even real estate and the mortgages cut on it.
What fueled the crisis last time were subprime mortgages (below “good credit” standards) and the creatively deceptive ways to package (and hide) them within artificial paper called synthetic debt obligations (SDOs).
Clones of this paper have already made their appearance in the current energy junk bond mess as investment banks look for ways to collateralize suspect debt and “trade it forward.”
The most pointed and concerned questions I fielded at Windsor surrounded this matter. Companies, central banks, and government officials are paranoid about this problem recurring on their books, especially when it comes to the main position energy occupies in virtually everything affecting impacting on wider economies and markets.
But don’t worry.
This time around, we have a response.
As the energy debt market dries up and more desperate companies turn to questionable derivatives to bridge widening gaps, there is a way to play the situation for some short term gains. I’ll show you exactly how soon.
So stay tuned.
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