How to Trade the Energy Junk Bond Crash

How to Trade the Energy Junk Bond Crash

Yesterday, crude oil hit a fresh 12 year low.

When futures markets opened, West Texas Intermediate (WTI) crashed by 2.7% to US$28.60 per barrel. Brent Crude fell by 3.7% to US$27.67 per barrel.

It’s not pretty story. But, most of the carnage should be over for now.

If you want to have a punt on the oilers, now is the time. The risk to reward ratio looks compelling for a quick trade. As I explained yesterday, crude should bounce by 15–20% in the near-term. This should see it revisit the US$35–36 per barrel resistance level.

Remember, the bounce should be just be that — a bounce. There’s a good chance the major low will follow. Nevertheless, the damage has already been done to the oil industry. So, expect a major energy crisis in the months ahead.

I’ll explain…

Just being a blue chip doesn’t make a stock safe

To begin, let’s turn to Jeffrey Gundlach, the founder of US$85 billion DoubleLine Capital, the world’s largest bond fund. Gundlach, like myself, also expects a short term bounce in crude oil. According to Bloomberg, Gundlach said:

Oil prices, which fell to 12-year lows in the last week, seemed to hit a floor Tuesday and may climb back to $45 a barrel.

Unfortunately, while this sounds good, it won’t change the story. As Gundlach explained to Bloomberg last week:

‘Such a price rebound still wouldn’t be enough to save highly leveraged energy firms, which will lead to more credit defaults.

Indeed, it won’t matter if there’s a 50% bounce in crude oil. The most indebted shale producers keep struggling. In the months ahead, multiple energy defaults are likely. When this happens, global stock markets could plunge by another 10–15% from today’s level.

Unfortunately, it’s not just the smaller and ‘no-name’ operators at risk of going under.

What can go wrong, will go wrong…

Late last month, Freeport McMoRan’s [NYSE:FCX] co-founder James Moffett was shown the door. Moffett is an oil industry tycoon. A true pioneer and wildcatter.

Leading to his downfall, Moffett made a fatal mistake in 2013. He paid US$2.1 billion for McMoRan Exploration Co (an oil-and-gas company the parent company had separated from in the 1990s). And US$6.9 billion for Plains Plains Exploration & Production. The deals assumed oil prices would remain higher forever.

As you can guess, the fairy tale didn’t play out. In the 18 months following Moffett’s transactions, Crude oil crashed by 77%. At the same time, Feeport McMoRan’s debt rose five-fold to US$20 billion. Not surprisingly, the company’s share price plummeted to a 15 year low. You can see the recent crash on the chart below:


Source: Yahoo Charts

Click to enlarge

Unfortunately, the nightmares not over for Freeport McMoRan.

If prices stays at these low levels, Freeport’s in big trouble. According to its credit-default swaps, there’s a 79% chance the company will go belly up in the next five year. Meaning, its US$4.85 billion blue chip market capitalisation is nothing more than a smokescreen.

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The bankruptcies are coming

Freeport McMoRan isn’t the only ‘blue-chip’ company affected by lower crude prices.

BHP Billiton [ASX:BHP], the world’s largest miner, went on a US$20 billion shopping trip in 2011. It became the largest overseas investor in US shale. Recently, the company announced a US$4.9 billion (after-tax) write-down on its US shale assets.

Not surprisingly, BHP Billiton’s share price keeps struggling. Although it isn’t at risk of bankruptcy, assuming BHP’s share price can’t go any lower is a mistake. In fact, it’s worth revisiting what I said on 11 December:

While it looks cheap on paper, I’d stay clear from BHP for now. With falling commodity prices and US$3.5 billion in debt due next year, there’s a good chance BHP’s dividend will be cut for the first time in decades.

Remember, BHP’s merely another over-leveraged commodity company. ‘Blue chip’ means nothing.

BHP bought a bunch of assets at the top of the cycle. If commodity prices keep falling (as I expect), BHP’s profit margins will be hit hard. There’s a chance it won’t be able to repay its US$3.5 billion debt this year. So expect a more asset write-downs and a lower share price in the months ahead.

This is a cause for concern. Historically, defaults come after the majors write down their assets. Remember, they tend to have the lowest cost assets.

Don’t go whistling through the graveyard

At US$35 per barrel crude oil, nearly every US shale company is cash flow negative. So, energy firms are burning through cash and other forms of liquidity (i.e. bank revolvers and term loans) to stay alive.

The clock will only tick for so long.

The US shale sector is facing an avalanche of defaults. The table below shows 25 deeply distressed oil companies.


Source: ZeroHedge

Click to enlarge

Pay attention to the middle column, titled ‘change’. It shows how much banks have cut the borrowing facilities of the US shale operators. Remember, when companies can’t repay their debts, banks will reduce their borrowing facilities.

In the case of New Source Energy Partners, banks rolled back their borrowing facility by 51%. If you didn’t know, New Source Energy Partners [OTCMKTS: NSLP] had a share price of US$27.66 in July 2014. It’s now a penny stock.

Seeing lower oil prices and profit margins, banks will roll back more borrowing facilities in the months ahead.

Before you know it, banks will say enough is enough. The lights will be turned off.

Remember, we’re not in the early days of the junk bond crisis. We’re near the point where it goes ‘bang’.

Markets are showing clear signs the game’s over. In exchange for the high risk of default, junk bonds offer punters higher interest rates (yields). Yields rise when energy-related debts face repayment challenges. When this happens, junk bond prices fall. You can see this trend in motion on the chart below.


Source: Bloomberg

Click to enlarge

Indeed, junk bonds are priced at a 20% discount to their par value. This means, assuming one year to maturity, you can buy a $100 bond for $80 today. The discount indicates punters are worried they may not be paid.

A lot of these bonds are due to be refinanced this year. So, it’s a question of ‘when’ the defaults will come. With the writing on the wall, stock markets should struggle in the months ahead. As Gundlach told Reuters,

The stock market is having a hard time (after the December rate hike). This is not a time to be a hero. I think we’re going to take out the September low of the S&P 500.’

This is unlikely to be a 2008/09 type crash. Back then, the stock market crashed by 50%. This time, we’re looking at a 15–30% crash from the November high on the Dow Jones. So, when the market corrects, don’t panic and sell. Instead, be a contrarian.

Buying the best resource companies now should pay off. But stringent financial statement analysis and sector analysis will be paramount. Just because a company is deemed a ‘blue chip’, doesn’t make it safe. In fact, shorting a number of the ‘blue chips’ should pay off in the months ahead.

If you want to know the best time to buy commodities, and the best miners digging them up, check out Resource Speculator. Remember, prices are low now, but we’re facing major international conflict in the years ahead. While that isn’t something I want, commodities tend to rise during times of war. If you want to know more on this story, click here.

Regards,

Jason Stevenson,

Resources Analyst, Resource Speculator

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Jason Stevenson
Jason shares his extensive knowledge of Australia’s mining sector as Money Morning’s dedicated resource analyst. Whether it’s iron ore, gold, copper or lithium, you can rely on Jason to give you in-depth analysis of the biggest and most important sector of our economy. Jason provides in-depth research to Resource Speculator, Australia’s premier resource investment advisory. If you’d like to know more about Jason’s financial world view and investing philosophy then we recommend you join him on Google+. It's where he shares investment insight, commentary and ideas that he can't always fit into his regular Money Morning essays.
Jason Stevenson is Money Morning’s resource analyst. He believes that the best way to make money is, and always has been, to back Australia’s best explorers, miners and refiners.
Before joining the team at Money Morning, Jason worked at boutique firms which advised fund managers and high net wealth clients where to invest. Now he brings that expertise to Money Morning, where he provides readers with his take on the Aussie resource sector. Whether it’s iron ore, oil and gas, gold or lithium, you’re guaranteed in-depth analysis of Australia’s biggest and most important sector. Jason is also the analyst for the leading resource investment advisory Resource Speculator. This is where he shares the best mining prospects and natural resource plays he finds on the ASX. Official websites and financial e-letters Jason writes for:

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