Summary
- Energy prices have collapsed with unwinding of massive net-long positions
- Weak demand and rising supplies also weighing on the sector
- Slide in prices puts debt of certain issuers at risk of default
- Until we see signs of stabilization in energy credit markets, bottom to remain elusive
The Energy sector has taken an absolute beating in the last several months and is now down double-digits for the year after battling for the top sector in the middle of the year.
Source: StockCharts.com
The decline in the energy sector stems from a sharp slide in crude oil from just under 0/barrel in July to roughly /barrel today with a similar slide in gasoline prices where the national average fell from a high of .67/gallon in April to .62/gallon as of this writing.
The Great Unwind - Speculators vs. Smart Money
There are several contributing factors to the slide in oil prices and one of them is the unwinding of the large non-commercial (AKA: speculators) net long position in oil. As a percentage of total open interest, speculative longs reached ridiculously elevated levels this year as traders incorrectly bet on higher oil prices. Their net long position as a percent of total open interest (red line below) has come down with the recent slide but still remains near multi-decade highs excluding this year’s ramp up and indicates speculators may have more to go to unwind their large long position in oil.
Source: Bloomberg
While speculators were betting on higher oil prices, commercial hedgers (AKA: “smart money”), like the transportation industry, had their largest net short position as a percentage of total open interest ever and have made a killing shorting oil recently. With the slide in oil, commercials have reduce their net short position but it still remains elevated as it appears commercials are expecting lower prices.
Source: Bloomberg
Trend support in the mid-s suggests commercials may be correct.
Source: Bloomberg
Supply and Demand
While the unwinding of speculative oil paper bets is contributing to the slide in oil prices, there are other fundamental reasons as well. When looking at OECD data from the International Energy Agency (IEA) we see that oil stockpiles for the Americas currently rests at a 5-year extreme and total OECD supplies are near a 5-year average and have been trending higher all year.
Source: IEA
Currently, total OECD demand data isn’t encouraging for higher oil prices either as demand recently hit close to a 15-year low after falling dramatically this summer.
Source: Bloomberg
Looking at the U.S., we are still consuming less oil than we did near the peak in 2007, roughly two million barrels a day less.
Source: Bloomberg
Global demand doesn’t look set to improve any time soon as OPEC cut its 2015 forecast for crude oil demand to a 12-year low.
Oil Price Hit by OPEC Numbers as Saudis Stand Firm on Output
The Organization of Petroleum Exporting Countries cut the forecast for how much crude it will need to produce next year by about 300,000 barrels a day to 28.9 million a day, the least since 2003. The group’s three largest members, Saudi Arabia, Iraq and Kuwait, are offering oil to Asian buyers at the deepest discounts in at least 6 years.
It appears that the oil industry may be going down the path faced by the coal industry as Jeff Rubin, former Chief Economist and Managing Director of CIBC, argued in his October interview with Financial Sense Newshour back when oil was trading around :
"[W]hat has happened to the coal industry is about to happen to the oil industry, or at least the high cost segments of the oil industry, which would include most of the new oil coming out of North America: shale or converting tar sands into bitumen. And I think that the goalposts are moving—that what we're seeing already is only a harbinger of what's to come and that we're going to continue to see broad disinvestment from the carbon sector not so much for reasons of saving the world but more for reasons of saving your portfolio and I think that's going to be as valid a statement in the S&P 500 about coal and oil stocks as it's going to be in the Canadian TSX as it’s going to be in the Sydney All Ordinaries in Australia. We're going to see carbon stocks become more and more an albatross on index performance and we're going to see not only slower economic growth but actions taken by individual countries that will increasingly be hurtful to valuations of those types of stocks."
Credit Markets Signalling Possible Trouble
The hit to the energy sector is beginning to cause some angst in the credit markets as the sector was one of the highest issuers of junk bond debt in recent years and has the highest option adjusted spread (a measure of risk) for both investment grade and high yield of any sector. Shown below is the investment grade option adjusted spreads (OAS) for the ten sectors of the market with energy currently showing the greatest risk at 189.3.
Source: Bloomberg
Things look much worse in the junk bond market (AKA: high yield) where the OAS for the energy sector is 942.6:
Source: Bloomberg
What's the default risk for the S&P energy sector as a whole? I recently looked at the S&P 1500 Energy Index, which has all of the energy stocks of the S&P 500, 400, and 600, and analyzed them using Bloomberg’s default risk model. Bloomberg’s model classifies issuers into three categories: investment grade (IG), high yield (HY), and distressed (DS). Each category has sub ratings shown below along with their associated 1-year default probabilities.
Source: Bloomberg
Luckily, there were no companies in the S&P 1500 Energy Index that were in the distressed category but there were several classified as high yield with the worst receiving an HY4 rating, which was Arch Coal (ACI).
Source: Bloomberg
The remaining companies within the S&P 1500 Energy Index were classified as investment grade with 12 members on the verge of moving into the high yield category with their IG10 classification.
Source: Bloomberg
For signs that the energy market is stabilizing we need to see the default risk for the sector improve, which clearly hasn’t happened yet. Option adjusted spreads on the investment grade energy sector index are nearing a 5-year high and for the high yield energy index spreads have exploded to nearly 1000 as default risk in the energy high yield market becomes worrisome.
Source: Bloomberg
The stock market tends to rally into year end and we could see signs of stabilization in the energy sector. This would provide some relief to nervous investors worried about fallout. However, I would keep a close eye on the credit markets for confirmation of a bottom. Most often, divergences between stock markets and the credit markets resolve towards the latter. For example, while the SPDR S&P Oil & Gas Exploration & Production ETF (XOP, black line below) began to rally with the rest of the market beginning in the middle of October, the OAS spread for the investment grade energy index continued to worsen (shown in red and inverted for directional similarity below). We need to see spreads for energy debt issuers come down for signs of stabilization, which just isn’t present at the moment.
Source: Bloomberg
Summary
The oil markets appear to be following the sad state of affairs as coal, which is in a prolonged bear market. Oil prices have tumbled as bullish positions by speculators are being unwound against a backdrop of weak energy demand and rising supplies. The sharp decline in prices is putting stress on the energy complex as risks of default pick up.
The sector is faced with a “darned if I do and darned if I don’t” dilemma in that if they want to stop the decline and help stabilize prices they need to cut production to bring supply and demand into balance, which will lead to slower cash flow and earnings being used to service their debt. However, if they keep production rates at current levels, prices will undoubtedly fall further and reduce earnings and cash flow, which will increase default risk.
There will be some stabilizing level between supply and demand where prices firm. Where that level is remains to be seen but a close eye on the credit markets will help shed light as this process unfolds. Current OAS spreads for the high yield and junk bond markets for the sector continue to worsen as signs of a bottom remain elusive. Investors holding risky energy stocks may want to review the Bloomberg default risk table above to help detect if they have any landmines in their portfolios.
