Many Analysts See a Bond Bubble Forming …
U.S. corporate bond issuances hit a record high this month and are on pace to beat 2014 levels, when corporate bond sales totaled $1.5 trillion.
Question: Why is this happening?
Answer: Corporate issuers are availing themselves of low interest rates.
Part of the reason corporate debt markets have boomed over the past six years or so is that investors have been searching aggressively for yield, and have been willing to take on more risk—even for deals with near junk-bond ratings—to get far better returns than they’d realize, on say, Treasury bonds.
Many analysts see a bond bubble forming, however, and these concerns may be especially justified for bonds issued for oil and gas projects. Oil and gas industry debt has increased by more than 50 percent over the last five years, and, according to Bloomberg News, U.S. oil and gas exploration and production firms have issued approximately 17 percent of all junk bonds on the market.
The oil-and-gas segment of the debt market is at risk today because of the 50 percent drop in oil prices over the past year (from almost $100 a barrel last summer to about $50 today), a drop that has had two big effects on the financial stability of companies:
- It has substantially reduced the valuation of assets, which will likely reduce net earnings and potentially lead to downgrades that affect ability to borrow and ability to pay debts.
- It has undermined project economics for companies that have issued debt with the assumption that oil and gas exploration and production firms need a rising market in which $80-a-barrel oil (compared to $50 today) is supportable over a reasonable time horizon. Put another way, with prices as low as they are today, U.S. oil and gas companies that sold bonds to finance capital expenditures have less revenue and less cash on hand now to repay debt.
All this raises the short-term risk of default or bankruptcy, either of which would be bad news for bondholders. By some estimates reported by major news organizations, as much as $200 billion in oil and gas exploration debt may be at risk of default.
Concrete signs have begun to appear that all is not well. In January, WBH Energy, a Texas-based company, drew headlines for filing bankruptcy, and Reuters said WBH “may be the first U.S. oil company to do so since crude prices started tumbling six months ago.” Another similar Texas company may be in trouble: Sabin Oil & Gas, according to recent published reports, saw the value of its bonds plunge from above par in September to 49 cents on the dollar.
INDUSTRY STRATEGY AND RESPONSE
Oil and gas exploration firms may seek short-term debt restructuring to maintain cash flow, and they may well find it. The law firm Latham & Watkins a few weeks ago posted an article explaining a range of options to ensure short-term liquidity while managing default risk.
Not all at-risk exploration and production companies are equally vulnerable. Those best positioned to avoid default are those already in negotiations with lenders to modify terms. Companies with quality production sites and good location may even be able to issue additional debt.
How long this down cycle in prices will persist is unpredictable. Oil and gas remain profitable under fairly marginal scenarios. The reinvestment process is at stake, evoking a number of questions.
On what terms will robust reinvestment take place? Will normal cyclical behavior of reorganization at lower valuations, and short-term investor losses pave a path out of this down period? Will lower oil prices result in acceptance of lower profits in order to stimulate investment, which would be a new norm? Are we looking at longer-term realignment of interests in financing of oil and gas or are we looking at substantially changed market players, market drivers and market power?
Only time will tell.
Lisa Anne Hamilton is an IEEFA regulatory consultant.
