Policy of near-to-zero or zero interest rates has one purpose – stimulate the economy. The non-existent incentive to accrue savings and a cheap credit consequentially push society to ‘buy’ which in turn should start-up the economy. The case against this way of thinking has strong arguments and many examples.
The game-changer here is that the policy of a free-credit always leads to speculative bubbles and a waste of capital on unparalleled scale. Example? The Oil and Gas sector in the United States and Canada.
Seventies were the booming years for the Oil sector in the US. Peak production was reached back then and ever since it has been slowing down, landing on the lowest level in 2008. Simultaneously in 2008 the famous shale revolution started. Oil needed 7 years for its production to skyrocket by 70% and meanwhile gas climbed 28%.
The cost of producing oil from shales in the USA is between 80-90 USD per barrel. Production was profitable until mid-2014. In contrast commercial shale gas production generates losses since 2009.
Revenues vs production costs
Oil production was the money-making enterprise in 2011-2014. Gas production on the other hand, was deeply in red in this time frame. Expenditure focused on increasing production rose quicker than resulting revenues both in oil and gas case. Zero-interest rate and ever growing credit is the only way to endure this strategy.
Having an option of choosing between instruments/government bonds with zero interest rates or ‘shale bonds’ generating 6-8% per annum, investors picked the latter. Every trade made resulted in booked commission on Wall Street, investors get their money’s worth from interest rate and companies from the Exploration and Production sector could satisfy their hunger for capital to sustain production.
In theory everyone was winning. In practice Oil and gas sector’s revenues were outclassed by expenditures. When comparing revenues of the sector (blue) and capital expenditures (red) one must quickly realise that since 2010 the E&P sector has been fighting with negative cashflows.
Indebtedness of the sector
Only by investigating the amount of accrued debt in the sector it is possible to get the real picture of this problem. Since 2011 it nearly tripled from $100 bn to $290 bn. Low price of oil barrel and gas make liabilities to grow by $25 bn per quarter.
When describing a magnitude of this problem it is inevitable to revisit memories of subprime MBS (mortgage-backed securities) crisis of 2008. Neither then nor now those securities have high chance to be repaid. When barrel of oil was worth 100-110 USD in 2014 a substantial number of companies hedged the price of oil for several months ahead. This fixed the price of the barrel of oil delaying oil price crash but did not defend them against it.
Today there is only few that are able to sell a barrel above the market price. Some hedged the price for another few months when the it hovered around $60/bbl in June. Strategy only marginally limiting loses. Again.
The gravity of loss-producing shale in the USA is insurmountable and the only logical solution would be to shut production and acknowledge the bankruptcy. However, the problem lays on the side of investors still willing to finance insolvent producers.
The chart below underlines the scale of the challenge ahead. Today the share of the revenues spent on servicing debt is at record high 83%, double the level from two years ago.
The challenge for the whole corporate bond sector
The E&P companies and their disastrous record affect not only their personal and institutional bond holders. Bankruptcy of numerous energy companies pushed the opinion about an ‘energy sector debt’ from bad to worse.
Investors finally started to focus on whether they can actually get their money back rather than an interest offered in an undefined, far future.
If you buy bonds of a corporation generating nothing but losses and its functioning is possible thanks to continuous infusions of a debt then it perfectly fits the typical Ponzi scheme. Everything works fine until there is a queue of new investors. When the queue is gone things get brutal.
It was just one year ago when shale companies could borrow at 4-5%, slightly higher than high risk, high reward Bloomberg high yield corporate bond index. Today energy companies have to offer at least 11% to get any new capital.
I decided to write about the shale sector in the context of short selling bonds. This situation mimics the MBS crisis of 2008 for me.
Back then, banks were encouraged to sell overpriced home mortgages. ‘Ninja’ (No Income, No Job) clients were widely accepted and no endowment was required. It was foreseeable that most of those loans would never be paid back. Similarly the energy sector debt is doomed to share the same fate.
It is worth noting the fact that during the crises the capital flights out of low rating bonds as fast as out of stock markets. Chart below shows how interest rate of junk bonds increased during 2008 slump. Yield of bonds rated CCC or less reached over 40%! This means that bond prices crashed from 40-70% depending on their maturity. Sales were comparable to NYSE stocks falls.
I advise caution against immediate short selling shale and largely high yield corporate bonds. The Corporate bond sector (excluding financial sector) in the US is valued at 7.7 bn USD. It is 50% bigger than a decade ago.
In the last 3 months corporations borrowed more than they paid back in 2 years (2009-2010). In normal circumstances and in a normal reality short selling this kind of bonds would be very easy.
Unfortunately right now markets are distorted after interventions of the central banks. In case of any danger the FED can increase supply of dollars and buy up energy sector bonds that lack investors willing to buy them. Now THAT is called the invisible hand of a free market :) Pumping another billion USD into the market would be enough to calm the situation down. For the masses some explanation about energy safety of the nation and the extraordinary steps that follow should be enough. Ultimately we should be next Saudi Arabia or Qatar, right?
The most interesting for me personally is the potential intervention in bond market by the FED in the light of expected hike of interest rates. One of my colleagues, with whom occasionally we consult our decisions, recently suggested that raising interest rates could lead to insolvency of the whole shale industry and very cost-effective takeover of E&P companies’ assets. It was indeed in 2007-2008 when the biggest consolidation in the financial industry took place. Today the 5 biggest US banks control over 80% of the market. The meltdown which supposedly decimated banking sector in the US led to merely to strengthening biggest banks and eliminating competition.