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The bond market is about to enter a phase we haven't seen in over 70 years…
A rising interest rate cycle.
A trend that has only been accentuated by the U.S. Federal Reserve's aggressive plans to accelerate interest rate hikes and ongoing concerns over an impending major stock market correction.
And while it is too early to jump on the "death of the bond bull market" sentiment swirling around Wall Street, the current direction of interest rates could be worrisome for U.S. oil producers.
You see, any way you look at it, a wide swath of U.S. oil and natural gas producers are going to take rising rates on the chin. Bankruptcies, mergers and acquisitions, and asset sales one step ahead of the sheriff will be increasing.
That doesn't mean there's no profit to be made here… On the contrary, in fact.
Those are all opportunities.
But it does mean we may have to tread carefully…
How the Fed Could Hammer U.S. Oil Producers
The current collision between Fed interest rate policy and U.S. oil and gas operators reminds me of a problem that first started to appear in late 2014.
At that time, the collapse in oil prices was underway and one of the pervasive elements of U.S. oil producers was first revealed…
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Virtually all U.S. publicly traded or privately held oil and gas producers are "cash poor."
That means the companies rely on debt to cover the bulk of near-term operating costs. Proceeds from sales are (more often than not) employed to cover dividends or stock buybacks. In fact, if left only to the revenue derived from sales, many producers would go belly-up rather quickly.
As a result, they resort to taking out credit.
Now, this is not as strange as it may seem.
In fact, for most producers, this was a very manageable arrangement.
But it does have a downside if the situation becomes more constricted…
The Problem with Energy Debt
The ability to use oil that hasn't been drilled yet as collateral for a line of credit becomes problematic once the price that oil can command declines significantly.
Furthermore, as oil and natural gas prices decline (and the ability to obtain new credit is restricted), the high-yield energy curve rises faster than any other bond sector.
Which is precisely what began in earnest at the end of 2014.
2012-2014 spread of high yield energy bond rates to high yield rates; lhs = "left-hand side," the bid or buy price. Source ASIDA analysis
You see, as the spread intensified, it put downward pressure on U.S. producers.
For example, as oil prices started to fall in 2014 after OPEC opted not to cut production, equity values for publicly traded American companies declined as well.
But the overall affordability of available credit declined even faster.
Source: ASIDA analysis
The result was the largest bankruptcy spike in decades.
Which brings us back to the situation developing currently…
You see, there is a historical connection between a widening yield spread and company defaults.
In fact, as you can see in the chart below, these two have moved in tandem with each other for decades…
Now, some analysts believe that the situation we're seeing today won't be as bad as what we saw back in 2014-16, and there are three predominant reasons why…
- Oil prices are some $20 a barrel higher
- Operations have become more efficient
- A balance is forming between supply and demand
But if you take a closer look at the situation, none of those reasons are all that positive….
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.
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