Plunging oil price could trigger next GFC

Mark Mulligan
November 27, 2014
The Age
It’s grip on oil weakening, OPEC is split on prices
The falling oil price will place stress on the global junk bond market, experts say, with US energy companies at increasing risk of default.
The plunge in the price is “the most significant risk that could potentially deliver a volatility shock large enough to trigger the next wave of defaults” in junk bonds, Deutsche Bank said.
According to the bank, energy companies now account for about 15 per cent of outstanding issuance in the non-investment-grade high-yield – or “junk” – bond market.
It warned in a recent report that many of these issuers would come under severe financial stress if the price of benchmark West Texas Intermediate (WTI) crude dropped from its current level about $US74 a barrel to $US60.
“Our calculations suggested that a further 20 per cent decline in oil prices to roughly $US60 a barrel on a WTI scale could push the whole US energy sector into distress,” the report said.
Deutsche bases this scenario on average debt leverage ratios of previously distressed issuers in all non-financial sectors. Once the ratio of debt to enterprise value (D/EV) exceeds 65 per cent, a company becomes vulnerable to default, it says.
“At $US60 a barrel our calculations have shown that the average D/EV ratio could reach 65 per cent,” the bank said. “And historical evidence suggests that issuers exhibiting higher ratios carry significant risk of restructuring.”
The precipitous fall in oil prices this year has made Thursday’s meeting of the Organisation of Petroleum Exporting Countries (OPEC) one of the most watched events of its type in months.
With the conflicting interests of the cartel’s 12 members likely to prevent any meaningful cut in production to halt the commodity’s slide, relatively low prices look set to be around for a while, according to most analysts.
The 30 per cent decline, to around $US78 a barrel, has proven a boon to consumers but added to the woes of already-troubled oil-producing, OPEC economies such as Venezuela, Nigeria, Iraq and Iran.
Weak prices are also weighing on hundreds of small to mid-sized energy companies in the US, and raised the spectre of the developed world’s first credit bubble since the global financial crisis.
Shale oil and gas boom
Keen to cash in on the country’s shale oil and gas boom, exploration, production and services companies have in recent years capitalised on ultra-low lending rates to tap the country’s vibrant corporate debt market for operating funds.
Global bond fund manager PIMCO agrees risks are building in the energy segment of the high-yield market.
In an interview with Fairfax Media, chief investment officer for global credit Mark Kiesel said the firm, after years of research, had steered clear of lower-grade exploration and production (E&P) companies and drilling operations.
“Is there risk in the sector? Absolutely,” he said.
“We are avoiding it; we think the drillers are going to be very ­vulnerable; we think we’re going to see downgrades.
“We think some of the higher-cost E&P companies are going to be under significant pressure.”
Instead, PIMCO has more exposure to what the industry calls “mid-stream” companies, involved mainly in infrastructure for extracting and separating gas and gas condensates.
“We have been favouring more the investment-grade names, the higher-quality names,” he said. “And we have invested in a handful of high-yield names, but they tend to be the double B-rated issuers, so the highest-quality sub-sector of the high-yield market.”
He says the danger level for corpor­ate defaults in the sector ranges widely, depending on the technology in use and the type of hydrocarbon being ex­tracted.
“You’ve got companies in the United States that can be profitable at $US45 to $US50 a barrel,” he says.
“You’ve also got Canadian oil sands players which need $US70 or $US80.
“There’s a wide range when it comes to calculating who gets hurt and who can actually survive.”
In any case, he is among those who doubt OPEC on Thursday will agree to dramatic supply cuts to nudge up the price. Nor will individual energy companies capitulate until their finances become too stretched or they note sustained weakness in the price.
“I think the prices will stay lower for longer and the reason for this is that I think the companies themselves have become more productive, more efficient, due to technology,” ­Mr Kiesel said.
“The second thing is that companies are reluctant to cut production unless they think the price drop is sustainable.
“If you told all these companies that these prices are here to stay for the next three to five years, you would see a significant cut in capital expenditure.
“But they don’t know that – they don’t know if it’s going to be down for three to five years, or if it’s going to be down for three to six months.”
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