The collapse in oil prices has created a ticking time bomb in the energy markets.
You see, fueled by the market's easy money policies, a big portion of the expansion in the energy markets has been financed with high-risk "junk" bonds.
According to the latest estimates, energy-related issuances now account for almost 15% of the total $1.4 trillion junk-bond market. That's roughly $210 billion in high-risk debt.
As you might have guessed, the vast majority of these high-yield bonds were used to fund oil and gas deals.
Now a wave of credit rating downgrades is hitting the sector as oil prices reset at lower levels.
That has created a dangerous environment for both oil companies and bond investors....
Here's why: If oil prices stay low enough long enough, some of the weakest issuers in the junk bond space are bound to run into cash-flow issues.
That's why the high-risk end of the bond curve is currently overvalued by anybody's standards.
As Martin Fridson of Lehmann Livian Fridson Advisors noted about the high-yield space yesterday on Barrons.com, the difference between fair value and his option-adjusted spread (OAS) model had increased by a whopping 163 basis points (bps) or 1.63% since January 31.
That's more than the one standard deviation Fridson has identified as the "cutoff for defining an extreme."
According to Fridson, the "current overvaluation of high-yield bonds reflects investor complacency engendered by the Fed's lifting and stabilizing of financial markets with an unreasonably easy money policy."
In all, the OAS fair value for the high-risk portion of the bond curve is now 616 bps. The energy component of that, however, stands at 688 bps.
Of course, high-yield bond funds are an easy way to access the junk bond market.
These are usually exchange traded funds (ETFs) that can be purchased and sold as easily as regular stocks. They provide monthly or quarterly dividends that are well above market averages.
There are two leading ETFs in this category...
iShares iBoxx $ High Yield Corporate Bond ETF (NYSE Arca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSE Arca: JNK). Both currently provide annualized returns of 5.66% and 5.96%, respectively.
But the growth potential of these ETFs is also quite sensitive to the underlying strength of the paper, the so-called "covenant quality." That, combined with a decline in credit availability, means there could be a serious liquidity squeeze on the horizon for certain oil companies if crude prices stay low.
As analyst Andrew Barber put it last month: "Generally, cheap oil has been a boon for the overall U.S. economy, with lower gasoline costs meaning greater consumer spending power. In the thinly traded high-yield credit markets, however, the negative impact has been profound. Investors are now left to consider the working capital and interest coverage ratios of energy sector companies that were quick to raise capital in a low-interest-rate environment."
Unless there is a rise in oil prices, some oil and gas producers will be trapped in an unsustainable environment of declining profit margins and rising capital costs.
However, for most at least, this is not a short-term consideration. Provided a company has ongoing production from existing projects (where 80% or more of the capital expenditures are spent before anything comes out of the ground) and a ready market for that production, the net impact of the high-risk bond squeeze is likely still 12 to 14 months out.
[epom key="ddec3ef33420ef7c9964a4695c349764" redirect="" sourceid="" imported="false"]
The good news is there will be a gradual increase in oil prices over the next two quarters, with the futures contract curve for West Texas Intermediate (WTI) already in "contango." In a "contango" environment the current price of a commodity is lower than contract prices for future deliveries.
That may soften the price spread. But it probably won't be enough, meaning there are a few companies out there who will not make it.
That brings up the possibility of liquidations, outright bankruptcy scenarios, and an increasing level of merger and acquisition (M&A) activity. The M&A action in particular will provide us with some nice opportunities to make a quick profit. Given the severely oversold nature found in much of the oil and gas segment, expect some spikes in share value as the recovery sets in well above the market as a whole.
But the condition of the high-risk bond market is another indication that the recovery will be a rocky one.
The Impact of Falling Reserves: Faced with significantly lower oil prices, the replenishment of oil reserves is beginning to take a massive hit. In 2014, Royal Dutch Shell replaced just 25% of its production. That's just 300 million barrels of new reserves to replace 1.2 billion barrels of production. Here's why this massive crunch means higher oil prices...
