- The yield spread on the debt of junk-rated US energy companies has widened to multiyear highs in recent months as market volatility has impacted producers. That’s raised questions about their ability to service outstanding obligations.
- Thursday’s meltdown in the worst-rated tier of corporate debt demonstrates that there are big problems afoot for the US energy market.
- Producers will almost certainly have to pay more to refinance their debt in the future.
Yesterday’s market sell-off had unintended consequences for the US energy market, and signifies a major problem ahead.
High-yield debt — or the obligations of companies on the low end of the credit spectrum — has taken a hit after a week of volatility, spelling trouble for US credit markets. That’s particularly true for exploration and production (E&P) companies, which are among the largest holders of speculative debt.
For evidence of this, look no further than the exchange-traded funds that track so-called junk bonds. Both the SPDR Bloomberg Barclays High Yield Bond and iShares iBoxx High Yield Corporate Bond ETFs headed for 0.7% weekly losses on Friday.
Further, the iShares fund saw outflows totaling nearly $450 million for the week. Both of these junk ETFs are heavily weighted towards energy companies, as they make up around 15% of the funds.
Such hefty exposure to the oil market may lead to additional pressure on the high-yield market, which has already been showing signs of strain in recent months. It’s a dynamic that’s already been playing out in markets, and it’s having real consequences for US companies.
For example, last month a Texas-based E&P company called GEP Haynesville — which was making its debut as a high-yield issuer — pulled a $600 million bond from the market, making it the third US company to do so that week.
The situation is an unfortunate culmination of a period in 2017 that saw many sub-investment-grade energy companies load up on cheap debt. They were emboldened by a shale boom and loose lending conditions, which prompted ambitious expansion plans.
Those companies issued $42.5 billion of new high-yield bonds last year, according to data from Dealogic reported in the Wall Street Journal. One such example was Colorado-based Whiting Petroleum, which issued a $1 billion 9-year bond, rated B2, at 6.25%. It’s now yielding 7.8%.
Last month the yield spread — which measures the difference between a bond’s yield and benchmark US Treasurys — reached the widest gap since August 2017. Junk-rated borrowers in the oil and gas sector were paying 5.4 percentage points over investment grade US Treasuries, according to Bank of America Merrill Lynch data.
This signals that a potentially catastrophic situation is developing in the credit market. That’s because widening yield spreads indicate investors are worried about the underlying companies’ ability to service outstanding debt.
All the while, oil prices have risen in response to agreed production cuts from OPEC. But that could be short-lived relief, since the longer term outlook could keep prices deflated, putting additional pressure on the margins of shale producers. In the end, increased volatility is expected to keep dampening investor confidence.
“It must be kept in mind that US shale production remains as robust as ever while concerns over slowing global growth are fuelling fears of falling demand for Oil,” said Lukman Otunuga, Research Analyst at FXTM. “If escalating US-China trade tensions evolve into an all-out trade war, oil markets will certainly be one of the many casualties.”
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