Last month, Goldman put the exclamation point on a relentless move higher for crude prices when the bank wrote the following in a widely circulated note:
“The physical rebalancing of the oil market has finally started. While supply and demand surprised to the upside commensurately in 1Q16, leaving the market oversupplied by 1.4 mb/d, we believe the market has likely shifted into deficit in May. The 2Q16 deficit that we now forecast is occurring one quarter earlier than we expected mid-March, driven by both sustained strong demand as well as sharply declining production.”
While that marked a departure from their previous position, the bank was careful to remind the market that US production could well come back online should prices hit $50. Ultimately, that would make the move higher self-defeating. That is, until the weak hands (in terms of producers) are shaken out completely, there can be no sustained rally. Here’s the language from the note:
“Above $50/bbl is where activity will start to ramp up although operational frictions and levered balance sheets will slow this activity initially. This threshold has been explicitly stated during US earnings releases and is also consistent with the notable increase in hedging with calendar 2017 prices near $50/bbl. The ongoing open access to capital creates the risk that activity can ramp up meaningfully more near $50/bbl than we expect, with a US E&P raising equity this past week to ramp up its drilling activity.”
Note the reference to “the ongoing open access to capital.” Put simply: the door simply hasn’t slammed shut yet in terms of plugging funding gaps.
(Chart: Goldman)
As the old saying goes, “there’s a sucker born every minute.”
“Energy companies with a ‘junk’ credit rating are succeeding is selling more bonds, as investors regain their appetite for risky corporate debt — ending the freezing out of smaller oil groups from capital markets,” FT wrote on Monday, adding that “lowly rated companies in the oil and gas industry have sold more debt in May and June than in the preceding 11 months combined, and investor demand for two deals last week was so strong that bankers underwriting the transactions were able to increase both by 50 per cent.”
Here’s a look at returns on the Barclays High Yield Energy Index. Note that E&P bonds returned nearly 4% last month:
(Table: Barclays)
And here’s a look at how much spreads have come in:
(Chart: Barclays)
Whether or not this is justified is certainly questionable and investors don’t seem to understand that they are effectively ensuring that prices will remain under pressure by continuing to fund these companies’ activities.
The market has a habit of missing the forest for the trees. This seems to be another example of that tendency. One rig count number is meaningless in the grand scheme of things. The market is flooded with oil. When the fundamentals reassert themselves or when some Fed speaker goes off the (newly dovish) reservation and accidentally sparks a USD buying panic, prices will plunge again and anyone snapping up new issuance in the space will likely get hurt.
But hey, it’s all about finding yield. We’ll close with a quote from Sabur Moini, a high-yield portfolio manager with Payden & Rygel who spoke to FT:
“If you want a 7 or 8 per cent return, energy is the place you can still find that.”
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