Creditor Risk Aversion Rises Considerably in Energy, Metals & Mining Sectors

Not all is well with commodity producers.

Moody’s (MCO) has been very quick to point out that “the latest plunge by base metals prices and the renewed slide (in) crude oil prices are more ominous for corporate credit than was the earlier plummet by crude oil prices amid relatively steady industrial metals prices.” The credit rating agency’s industrial metals price index has dropped more than 10% in the past 20 days ending July 9, reaching levels not seen since the depths of the Financial Crisis in 2009. Moody’s industrial metals price index has fallen an incredible 25% since the same time stamp last year, something we’ve been witnessing anecdotally.

The International Energy Agency recently warned that the bottom in crude oil prices “may still be ahead.” Crude oil prices have fallen to three-month lows, with Brent crude ~$59 per barrel and US WTI ~$53 per barrel (USO). Global oil demand growth is slowing, with the agency stating that “world oil demand appears to have peaked” in the first quarter of 2015. Meanwhile, global oil supply is surging as both OPEC and non-OPEC countries increase output, with OPEC supply hitting three-year highs in June. Iraq, Saudi Arabia, and the UAE keep producing at a breakneck pace. Supply growth from Non-OPEC producing entities is expected to “grind to a halt” in 2016, with potential negative implications on US-based pipeline entities, where volume growth is key to distribution/dividend expansion.

What may not be completely factored into such credit models, however, has been the frantic dislocation in the Chinese equity markets (FXI), which have been falling like a rock as of late. Conditions in China are best described as nothing short of a panic, and implications across the country that imports the most oil have yet to be hammered out, but they can’t possibly be positive for the energy complex (XLE). Our latest equity report update across the energy space has forced us to implicitly assume billions and billions of incremental debt and equity capital issuances in 2016 to balance their models. Such a dynamic has not been lost on the credit rating agencies, nor have the high-yield markets ignored their risky-capital market dependency.

According to a post from zerohedge, “the renewed plunge in oil prices is kicking off a fresh round of debt concerns” with Bloomberg reporting that, according to Bank of America Merrill Lynch data, “yields on (speculative-grade energy securities) debt have climbed to an average 9.34%…levels that indicate investors view the typical security at high risk of default. Zerohedge has reported that bonds for Energy XXI (EXXI) and SandRidge (SD) are trading at 80-90 cents on the dollar, which doesn’t bode well for implied equity values at all. Bloomberg has reported that Swift Energy (SFY) is having a difficult time finding buyers for a $640 million loan, and some are calling the high-yield energy market a “silo of misery.”

From our perspective, we’ve yet to see the long-term implications of $40-$60 crude, as many implied equity prices across the energy space assume a return to $90-$120 prices. This has not been lost on us. We are forecasting a return to normalized conditions by Year 5 of our valuation models, but in many cases, normalized conditions are an ever-moving target, and a return to any sort of “normalcy” cannot be guaranteed, particularly in light of OPEC’s market-share retention tactics and talks of lifting sanctions on Iran. We would expect Iran to claw for market share should sanctions be repealed.

We view the following list of companies most exposed to ongoing creditor risk aversion. Of companies on the list, we only hold Energy Transfer Partners (ETP) in the Dividend Growth Newsletter portfolio, and we may look to eliminate the MLP on any upward advance in its share price. The pile of bad energy loans continues to increase.