Oil – The Black Swan – Part 1
No market event creates more fear in the hearts and minds of investors than that of the Black Swan. Wikipedia explains the Black Swan theory developed by Nassim Nicholas Taleb as follows:
- The disproportionate role of high-profile, hard-to-predict, and rare events…
- The non-computability of the probability of the consequential rare events using scientific methods…
- The psychological biases that make people individually and collectively blind…
Without question the most disruptive market event this year has to be the dramatic decline in the price of oil. In this series I’ll approach it both from the point of view of an on the line equity portfolio manager and as a top-down strategist looking at the bigger picture.
While I’m certain over the long run the lower price is a net benefit to the world, the staggering speed with which it has fallen is destroying debt and equity values throughout the energy sector. My crystal ball isn’t any clearer than yours but if there’s a Black Swan lurking you’ll probably spot it floating near some oil rig.
OPEC’s Thanksgiving Day Massacre
Energy markets were already feeling the pain before OPEC’s Thanksgiving Day decision to leave production levels unchanged. The news caught traders off guard forcing WTI crude down more than $7.50, the biggest one day plunge in years. It’s clear we’ve entered the next stage of the oil price wars and that OPEC is firing a warning shot across the bow of the U.S. energy complex.
One look at a few charts and you’ll quickly see that this is no ordinary sell-off. With some stocks down over 50% in just a few months something more sinister has to be taking place. High leverage along with high breakeven costs has put some names more at risk than others.
OAS Twitter Post
Oasis Petroleum (OAS) whose high debt levels I tweeted out on the Friday after Thanksgiving has fallen 37% just since that post and a staggering 75% since the highs in July.
The Junk Bubble
Stock investors are often blamed for bubbles, driving up stocks to unsustainable highs but if the truth be known, Black Swan events usually have their origins in the bond markets where the real leverage takes place.
Junk Bond investors have been pretty willing participants in financing the energy boom here in the U. S. In a recent Financial Times article discussing distressed debt they point out, within the broad junk market, energy accounts for some 16 percent, a fourfold increase over the past decade.
Perhaps one of the most glaring examples of trouble in the oil patch is Goodrich Petroleum (GDP), a company that develops oil and natural gas properties in Louisiana and Texas. GDP’s 8 7/8% of 2019 bonds now trade 60 cents on the dollar, down 42% since August. This is eclipsed only by its equity trading at 3.76, plummeting 87% since the highs of June.
With Debt/Equity over 284%* and poor interest coverage GDP may choose to lower their rig count to extend liquidity. That sounds like a death spiral unless pricing picks up soon.
Are Banks at Risk?
When there’s trouble in the debt markets, you can bet that banks are somewhere close by. On Friday, a trifecta of negative articles on energy related loans were published by Reuters, Fitch Ratings and LeveragedLoan.com. These sent a chill throughout fixed income circles leaving many questioning their commitment to the energy sector.
Reuters (Dec 5th) – lending to oil and gas companies totals $465 billion so far in 2014, according to Thomson Reuters LPC data – the highest annual total ever, and 29 percent higher than the previous record high of $359 billion in 2007.
Fitch Ratings (Dec 5th) – US banks with high concentrations of energy loans… BOK Financial Corp., at 19%; Cullen/Frost Bankers, Inc., 15% & Hancock Holding Company, 13%. They go on to say; Sustained pressure on oil prices could not only affect certain O&G loans, but also general consumer and commercial loans to consumers and businesses operating in energy-dependent regions.
LeveragedLoan.com (Dec 5th) – since Oct. 31, the share of oil and gas Index loans trading below 90 has jumped to 39%, from just under 1%.
Credit Default Swaps
As we dig deeper into the energy debt markets the picture doesn’t grow any brighter. Credit Default Swaps which provide bond investors with an insurance policy, have seen spreads widen.
The Fixed Income and CDS charts of Transocean (RIG) still an investment grade security show investor concern.
Larry McDonald, head of U.S. strategy at Newedge USA’s macro group hits the nail on the head when he says, “when high yield underperforms equity, a major credit event occurs. It’s the canary in the coal mine.”
Junk & Oil
Even though the percentage fall in junk bonds is a mere fraction of the fall in oil, it’s easy to see when you overlay the charts that since oil’s June peak they’ve been joined at the hip. Pretty soon investors will be screening junk bond funds to see just how much exposure they have to the energy sector.
The benefits of cheaper energy are well known and I doubt many consumers feel sorry for energy companies when they pull up to the pump to buy sub $3.00 gas. However, the energy boom here in the U.S. has attracted investors from every corner of the globe and seems to have tentacles that sprawl throughout our economy.
By definition a Black Swan Event almost defies discovery until you are looking in the rear view mirror. It’s complexity along with the psychological biases prevents us from fully understanding just how far the cancer may have spread.
It’s too soon to say whether the Black Swan has decided to nest here in the United States and while low oil prices will be a clear benefit for most the world, some countries are finding their economies pushed to the edge.
Tomorrow in Part 2 we’ll discuss the geopolitical reach of what has become the most significant economic event in years. With some petro economies in crisis I’ll attempt to follow the flight of the Black Swan.