We have seen exploding tankers in the Gulf over the summer, as well as drones targeting Saudi output and refineries, and yet the crude oil market can’t catch a bid. While geopolitical interruptions of supply can play a very big role in the direction of crude oil prices, under more normal conditions – not involving large intentional explosions – I would characterize the crude oil market as “weak and getting weaker.”
Oil may be the most political of commodities and it may dominate the dollar volume of commodity trading, but it is the health of the global economy that determines its price over the longer term, not temporary geopolitical supply interruptions, which arguably can cause big spikes. No exploding tankers and predator drones affect the supply of metals traded on the London Metals Exchange, and yet these metals are also sending a message of a “weak global economy getting weaker.”
It is rather interesting that the oil price right now is exactly double what it was in February 2016, when it was near $26, while the PHLX Oil Service Index (OSX), is about half the level it was back then. The reason is that oil service companies have their business leveraged to the price of crude oil, but new drilling methods have absolutely revolutionized that industry.
For example, the previous time we hit an all-time high in U.S. crude oil production (in October 2014), there were about 1609 crude oil rigs in operation in the U.S. The prices slumped because of the Chinese economic slowdown and so did oil production as the number of rigs plummeted to a hair above 300.
Now we have fresh all-time highs in U.S. crude oil production, above 12 million barrels per day (mbd), yet the number of rigs in operation is just 710 at last count and falling consistently by at least 150 rigs from the beginning of 2019. That’s because oilmen have figured out how to squeeze more oil from a single rig with horizontal drilling, blowing more sand in the drill holes, and all kinds of chemicals, as they managed to beat their all-time production record from five years ago with fewer than half the rigs.
China is the number one consumer of most hard commodities in addition to energy, so as the Chinese economy continues to deteriorate, the price of crude oil is likely to fall further, barring any geopolitical escalation in the Persian Gulf. This could mean that the number of U.S. rigs in operation will fall further.
The PHLX Oil Service index is trading at a 20-year low, not far from where it was when crude oil hit $10 at the tail end of the Asian crisis in 1998. It would not be an overstatement to say that some oil service companies may go out of business if the rig count falls dramatically and stays depressed for some time.
The thing about surging U.S. crude oil production is that a lot of those new drilling methods that make it possible also mean higher costs. Those costs have come down dramatically over the past five years, but they are still higher than conventional drilling, although they vary widely from well to well. An oil price decline below $40 will cause some production to get shut off as costs will rise above the market price.
Crude Implications for the Junk Bond Market
Overall, the junk bond market is doing well. Despite an inverted yield curve in the Treasury market – a result of negative interest rates in Europe and Japan, which are a direct consequence of ECB and BOJ monetary policy – junk bonds do not foresee a recession. In other words, the U.S. yield curve is inverted because of the bad state of affairs of the Japanese and European economies, and not the U.S. economy.
All that extra crude oil production was financed with a lot of debt, so a weak oil price will mean weak prices for energy junk bonds, particularly in the less liquid CCC part of the market, where energy has a bigger share. Lower energy prices have typically meant expanding junk bond spreads even for the overall junk bond market, but that is even more true for the junkiest of junk (CCC-rated or lower).
Right now, CCC spreads are elevated and rising, while the overall junk bond market shows credit spreads that are more or less normal, with the broader high-yield master index just a tad over 400 basis points (bps) over comparable Treasuries. I think this dichotomy of expanding spreads between the average junk bond and the junkiest of junk (CCC or lower) will continue to persist and get even worse as the global economy weakens further while the U.S. economy remains resilient.
Because of the very significant decline in U.S. interest rates – where the high of the 10-year Treasury bond yield was 3.25% last year, and now we are near 1.5% – a lot of covenants that deal with refinancing in the high yield market have come into play. A measure of the worst-case scenario for a buyer of high yield bonds, should such covenants be triggered, is called yield-to-worst (YTW), and the YTW metric for the S&P 500 High Yield Corporate Bond Index is under 4%, near an all-time low. There are 434 constituents in that junk bond index, so it is rather telling as to the state of affairs of the junk bond market.
Credit spreads are relatively tight for the average junk bond, save for CCC borrowers, and interest rates have dramatically declined in the U.S. in the past year. That would help riskier borrowers refinance at better rates and give a boost to the overall economy. Unless there is some dramatic geopolitical event and a fast escalation of the trade war, a recession in the U.S. does not look likely this year or next.
Equities Contributor: Ivan Martchev
Source: Equities News