Here Comes the Crude Oil Junk Bond Crash

Crude oil isn’t looking good.

West Texas Intermediate (WTI), also known as US crude, is trading around US$31.48 per barrel. Brent crude, the international benchmark, is trading around US$34.69 per barrel. Both have shown little sign of life this year.

It’s not a huge surprise…

The Wall Street Journal explained last week, ‘The more things change in the oil market, the more they stay the same: The agreement Tuesday between Saudi Arabia, Russia, Qatar and Venezuela to freeze oil output falls somewhere between symbolic significance and no change at all.

As I’ve said in the past, the chances of a major supply cut are nearly zero. For it to happen, ALL OPEC and non-OPEC nations would have to agree to cut output.

Good luck!

Iran is pumping out crude like there’s no tomorrow. It’s making up for lost market share since sanctions were dropped. Plus, given the Middle Eastern tensions, it’s unlikely to side with Saudi Arabia. Iraq has no intention of cutting production either. Moreover, there are thousands of US shale operators pumping out cheap oil.

If you ask me, lower crude prices are inevitable. Unfortunately, it will set off a major financial panic: the crude oil junk bond crisis.

I’ll explain…

Crude’s story looks bleak

In its February monthly report, OPEC said ‘ongoing excess supply, the weakening Chinese economy and lower seasonal heating demand have continued to weigh heavily on the market, making price movements to rather remain at a depressing level [SIC].

This is a huge problem. Over the past 18 months, crude oil prices have plunged by 70% to below US$30 per barrel. Of course, rising taxes and ever-so-burdensome regulations are stifling crude demand. But, let’s leave that story for another day.

Focusing on the supply events, many crude operators — and investors — thought the price drop would be short and sweet. Yet, crude oil prices have stayed low.

With lower prices starting to sink in, investors and companies are beginning to worry.

Many crude companies have break even prices above US$35 per barrel. With crude trading below this price, many producers are cutting spending. For example, Royal Dutch Shell [LON:RSDA] announced it would cut capital spending to US$33 billion this year.

And Shell is one of the bigger oil companies. With its mammoth, low cost oil fields it can withstand lower prices. It’s called economies of scale. Meaning, it can gain cost advantages by increasing size, output, or scale of operation.

Of course economies of scale eventually reach a point where they often fail…

Many crude producers are in big trouble

Many large crude producers have hit this point now. To obtain scale, they stretched their balance sheets by taking on more debt — too much debt. They’re at risk of going under. In the lower oil price environment, the debt and interest repayments can’t be repaid.

Santos Ltd [ASX:STO] and Origin Energy [ASX:ORG] are two Aussie oilers in trouble. As Courier Mail reported last month,

JUST months after its $25 billion LNG project at Gladstone was commissioned the Origin-led APLNG is unable to service its debt because of the collapse in energy prices, according to global credit rating agency Moody’s Investors Service.

Origin has rejected the claim but as the price of oil drops towards $US20 a barrel, Moody’s warned 175 global companies, including some of Australia’s biggest, that they were facing a potential downgrade of their credit rating, often a serious blow to a company’s ability to raise funds.

Origin’s financial fate depends almost exclusively on the oil price. According to company estimates, it needs US$38–42 per barrel to breakeven and repay its debt. At the moment, net debt (debt less cash) stands over AU$9.3 billion…significantly more than its market capitalisation of AU$7.1 billion.

It’s no wonder the dividend just got cut by 66%.

Remember, Origin isn’t alone. Santos is also in big trouble. Last year, Santos announced a net loss of AU$2.7 billion. This is huge — it’s nearly half of its market cap of AU$5.9 billion. Due to lower oil prices, the loss included asset writedowns of $2.76 billion after tax.

If crude averages US$32 per barrel this year, net debt should remain at roughly AU$6.5 billion. Remember, this is more than the market cap.

Adding to Santos’ problems, it owes AU$589 million next year. Assuming crude prices stay lower for longer, how will it repay this debt commitment? In my view, similar to Origin, another major capital raising is basically guaranteed.

Of course, these are just the big Aussie operators. Many of the medium sized Aussie crude players are in deep trouble. For example, Tap Oil [ASX:TAP] owes millions on its US dollar debt facility. It’s been trying to raise capital to stay afloat. If it survives, Tap’s shareholders are facing massive dilution — something that’s in store for more crude operators.

Remember, many companies don’t have the luxury of scaling their operations. Their balance sheets are too small, or too overleveraged. For example, Continental Resource’s [NYSE:CLR] share price has crashed by 75% in the past year and half. You can see the crash on the chart below.

Source: Yahoo Finance

Click to enlarge

At higher crude prices, Continental was one of America’s most prolific producers. It’s sitting on some of the juiciest crude in shale history. But that doesn’t help it now. Following lower crude prices and ongoing balance sheet destruction, it plans to reduce its investment by 66% this year. The days of US$80 per share are long gone.

Then there’s Chesapeake Energy [NYSE:CHK]. It hired lawyers to help restructure the company earlier this month. This isn’t just any company. It’s the second-largest US natural gas producer. But, unfortunately, size really doesn’t matter. Chesapeake’s share price has nosedived from US$20 per share to under US$2 in less than a year.

Surviving the future won’t be easy

It’s taken some time. But the real problems are just starting to emerge for the crude oil industry. Many operators are free cash flow negative. This means they can’t repay their debts.

Hellenic Shipping News reported yesterday,

Less than two months into 2016, and corporate defaults are on the rise. Three U.S.-based oil and gas companies defaulted this week, lifting the global tally for 2016 to 19, according to Standard & Poor’s.

Of the 19 defaults in the year so far, seven were missed interest payments, five were distressed exchanges, four came after bankruptcy filings, two because of de facto restructuring and one because of a missed principal and interest payment, said S&P.

S&P said the U.S. distress ratio, [a measurement of the amount of risk that has been priced into the high-yield — or ‘junk bond’ — market], started the year at 29.6%, the highest level since mid-2009. The ratio moved from 14.6% that year to a peak of 70%. The distress ratio… signals that companies need more capital.

To make things worse, Market Watch said ‘The number of global weakest links—or issuers rated at CCC or lower, placing them close to default—rose to 218 as of Jan. 27, from 195 as of Dec. 14. That is also the highest level since December 2009.

Remember, the sub-prime mortgage crisis of 2008/09? It’s back. Only, this time, the contagion risk lies in energy junk bond market.

Lower oil prices will cause a huge explosion of debt across the energy sector. When this happens, there’s no doubt the stock market will get hit hard.

The bottom line: choose your crude oil investments carefully. Just because it’s a ‘blue-chip’ energy company, doesn’t mean it’s safe.

At Resource Speculator I’m preparing readers for the energy junk bond crisis as well as many other potential dangers and opportunities I see in the resources market. If you want to know more, click here.


Jason Stevenson,

Resources Analyst, Money Morning

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

Money Morning Australia