Stage II in the Oil Stock Rout: The Junk Bond Market for Energy Companies Moves to Center Stage

12/16/2014 5:00 pm EST

Focus: FUNDS

Jim Jubak

Founder and Editor,

Every time the price of oil drops, shares of energy companies plunge because the financial markets are worried they won't be able to pay what they owe, and MoneyShow's Jim Jubak thinks the issue is a huge one for stocks in the sector.

We've got a really nasty negative feedback loop now going on between falling oil prices and the prices of energy stocks.

Every time the price of oil drops, shares of companies in the energy sector plunge because the financial markets, having extended billions in credit to US shale oil producers, are now worried that these companies won't be able to pay what they owe.

The problem for anyone trying to figure out where a bottom might be for stocks in the energy sector is that we really won't know how big a financial squeeze small to midsized US shale oil producers are facing until April-June, or so. That's when oil producers and their banks have to recalculate the value of their reserves. No one knows, at this point, whether banks will be hard-nosed about marking down those reserves—in which case many producers will find themselves in violation of their loan agreements—or whether banks will decide that cutting producers slack on calculating the value of their reserves is good for the banks themselves.

The issue is a huge one for stocks in the sector since the high yield—or junk—bond market that had provided the bulk of funding has shutdown as a financing source for many oil shale producers.

On Friday, December 12, US benchmark West Texas Intermediate was down another 3.57% or $2.14 to $57.81 a barrel for January delivery. Brent, the European benchmark is down 2.87% or $1.83, to $61.85 a barrel. Monday's action was smaller but still downward.

The fear—now that West Texas Intermediate has breached the $60 a barrel level—is that oil prices will continue to fall. To $50? Maybe $45? Back to the 2009 low of $40?

A constant din of demand projections, each lower than the last, keeps the pressure on. Friday's rout, for example, came after the International Energy Agency cut its 2015 forecast for global oil demand growth by 230,000 barrels a day to 900,000 barrels a day. That's a 20% cut in projected demand growth for 2015 just in one forecast.

And we're starting to see the very familiar Wall Street race to the bottom as analysts who competed to see who could raise their own forecast more now strive to see who can cut it lowest. For example, on Thursday, Ian Taylor, CEO of Vitol, the world's largest independent oil trading company, told an energy conference in New York that he thought even the most recent round of lower forecasts was too optimistic. Demand in 2015 would grow by only 600,000 barrels.

Lower oil prices mean lower oil company profits, of course. So even an integrated oil company such as ExxonMobil (XOM) with profits from refining and distribution offset the downturn in oil production, is down 7.48% in the 30-days that ended on December 11.

But the real danger in the oil patch is at those companies that loaded up on debt to expand production, especially during the oil shale gold rush. The US oil and natural gas from shale boom has been led by small and midsized companies that have, so far, spent more on drilling and exploration than they've taken in from selling their production. A lot of that shortfall in cash has been funded in the junk bond market. US exploration and production companies have issued $27.7 billion in junk bonds, so far, in 2014, according to Dealogic, compared to just $2.5 billion in 2003.

These cash-flow negative producers borrowed in the junk bond market at relatively reasonable rates since the Federal Reserve's efforts to keep interest rates low had led to a hunt for yield. At the end of November, the energy sector accounted for 16% of the $1.3 trillion junk bond market. That's up from a 4% share a decade ago.

Now, however, these borrowers see lower oil prices cutting into their ability to cover interest payments and redemptions on that debt.

But the bigger problem is that the many of these companies now find themselves effectively locked out of the junk bond market altogether. The decline in junk bond prices has sent yields on energy junk bonds soaring so that heavily indebted companies that might want to finance their cash flow needs can't on terms that they can afford. For example, the 9.25% notes issued by oil and gas explorer Energy XXI (EXXI) in December 2010 have fallen to 64 cents on the dollar and now yield 27.7%.

That's an extreme example, but by no means an isolated one. By the end of November, the average yield on junk-rated energy debt has climbed to 7.31% from 5.67%. But the energy sector is over-represented in the distressed end of the junk bond market. According to Martin Fridson, chief investment officer at Lehman Livian Fridson Advisors, 180 issues in the Bank of America Merrill Lynch high-yield index were trading at prices low enough to be called “distressed” at the end of November. That's roughly 8% of the junk bond market. But energy issues accounted for a whopping 29% of those distressed bonds, Fridson told the Financial Times.

In a December 8 report, Deutsche Bank predicted that about one third of companies with B or CCC credit ratings would be unable to meet their debt payments if oil dropped to $55 a barrel.

Other estimates put the potential default rate much lower, for 2015 anyway. Fitch Ratings, for example, calculates that the default rate on energy sector junk bonds will be just 1% or less in 2015. The bulk of energy sector junk bonds don't come due until 2017. In that year, $13.7 billion come due, Fitch calculates.

The rout in the junk bond market has thrown smaller producers back on bank loans and bank lines of credit for financing.

And here's where massive uncertainty comes in.

Bank lending to smaller producers is usually tied to the value of a company's reserves of oil and natural gas. When the price of oil and natural gas fall, the value of those reserves drops too. Which means banks could cut back on their loans and lines of credit when they do their next lending review. (Typically conducted twice a year.)

But that calculation allows for a lot of discretion in how banks price those assets. Banks could decide—if they wanted to put the screws to borrowers—to use current low prices or even project further price declines. But they could also decide that current low prices are likely to be temporary and use higher price estimates in calculating reserve values.

In looking at bank behavior during the 2008-2009 period when oil prices fell by 50%, Fitch Ratings has concluded that banks tend to reduce their estimates of reserve values far less than the drop in the price of oil would allow. Banks are reluctant to force borrowers to the wall by cutting reserve valuations on a 1:1 basis with declines in oil prices and are much more likely to leave loan and credit lines in place while asking for higher fees or improved loan terms, Fitch notes.

All this means is that, at some point, the generalized panic over liquidity issues for US shale oil and natural gas producers will have to turn into company specific panic over the shares of companies that have tapped most of their credit lines, that have hedged very little of their production for 2014 and 2015, and that have big debt loads to finance.

In its review to date, Fitch Ratings has tagged only one company, Kodiak Oil and Gas, as having big exposure in those three areas. Kodiak has already accepted a takeover offer from Whiting Petroleum (WLL). Other producers that Fitch cited as among companies that have used more than half of their credit facilities are Linn Energy (LINE), Breitburn Energy (BBEP), and Energy XXI (EXXI). Fitch also cited Clayton Williams (CWEI) as a producer that had hedged less than half its production for 2015.

This list is, unfortunately, incomplete and subject to revision...daily. On Friday, for example, Canadian producer Ivanhoe Energy (IVAN) reported that it was exploring the sale of the company and warned that it could default on an interest payment due on December 31. Shares of Ivanhoe fell 40% on the news.

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