Oil collapse will spill into credit markets

The suicidal price war among oil producers could worsen conditions in credit markets already spluttering from coronavirus.

AFR

Mar 9, 2020

The coronavirus has been a stark reminder of just how interconnected our world is. And as global financial markets continue to gyrate this week, those connections will become all the more obvious – and painful.

Last week Chanticleer explained how Australian fund managers were becoming increasingly concerned that conditions in US credit markets becoming much tighter, and were starting to look at the vulnerability of Australian corporate balance sheets which, while still in good shape, have seen borrowing levels tick up in the past 18 months.

The collapse in the oil price looks set to increase distress and potentially defaults in the market for energy bonds. 

Those fears have proven prescient, as credit spreads – there difference between US Treasuries and what companies pay for debt – continued to widen on Wall Street over the weekend.

But now there’s a new concern for credit markets – the oil price.

The dramatic 9.6 per cent fall in the Brent crude on Friday night to a touch above $US45 a barrel followed the breakdown in relations between Russia and the OPEC cartel and fears of a price war in the oil market as Saudi Arabia and Russia increase production just as global demand for oil is smashed by the coronavirus.

As respected oil market expert Fereidun Fesharaki told The Australian Financial Review, this is suicidal stuff in the current climate. He’s tipping the oil price could fall to as low as $US35 a barrel.

That will heap pressure on energy companies, and this will rapidly flow through to credit markets.

Estimates suggest that energy companies account for about 11 per cent of the high yield credit market in the US; a falling oil price makes it harder for these energy companies to repay their loans and raises the risk of defaults and distress in credit markets.

Indeed, an index run by a company called Ice Data Services showed the average US high yield energy bond is already “distressed,” as defined by the cost of corporate borrowing sitting at least 10 percentage points above Treasury yields. On Friday, energy bonds were almost 11 percentage points above Treasuries.

Nick Ferres, the chief investment officer of the Singapore-based, macro-focused firm Vantage Point Asset Management, is predicting more pain, similar what we saw back in 2016, when OPEC tried to force the price of oil down to hurt America’s emerging shale producers. Back then, defaults soared and distress spread.

If there’s a positive right now, it’s that credit conditions don’t look as tight as four years ago, Ferres says.

“While the US high yield spread widened by 56 basis points to 550 basis points on Friday, spreads remain only modestly above the long term average. In the 2016 growth scare, high yield spreads increased to 840 basis points at the broad index level.”

Of course, while energy is arguably the riskiest part of this market right now, unlike in 2016 the coronavirus means there are several other sectors likely to experience pain at the same time.

“In the current event a range of industries including airlines, travel and tourism among others are likely to be under material cash flow pressure,” Ferres says.