Consider that the consensus oil price forecast for 2017 stands at $60. The consensus view on oil sees stabilization and eventual rebound. But as the box nearby outlines, the risk scenario—one to which we ascribe higher likelihood than the market—suggests further declines. But how can declining commodity prices which function as a boon to consumption be bad for the outlook? Indeed, falling prices will help support the consumer and the economic outlook— eventually. But before we can realize those benefits, the financial market vulnerabilities from increasing defaults in commodity sectors risks spreading to a broader withdrawal of liquidity in credit markets.
Crude Realities
Despite crude oil prices reaching their lowest levels since 2009, significant downside risks continue to shape our bearish view on the commodity and on assets dependent on a rebound in energy prices. With OPEC production at near all-time highs and geopolitical and budgetary considerations forcing the key OPEC swing producer, Saudi Arabia, to continue its policy of full production for maximum market share, oil continues to be significantly oversupplied. Weighing on markets more recently is the anticipation of the removal of Iranian sanctions, as fears of 500,000 barrels or more per day can return to global markets as soon as the first quarter.
In the U.S., while rig counts have fallen precipitously and total U.S. oil production has declined from its peak, shale oil producers have done their best to cut costs and maintain production at price levels below what was once thought their breakeven points. In fact, recent estimates put much of the Eagle Ford basin, for example, profitable below $40. Companies have benefited from much cheaper operating costs as a surplus of equipment and labor have lowered the cost of production, and have also continued to increase productivity by drilling wells in more favorable formations. Investors also fear a surplus of drilled but uncompleted wells waiting to be turned on and a wave of futures hedging by producers as soon as crude oil prices rebound—keeping a long term ceiling on how strong a rebound can be.
The glut of crude oil has led to rising inventories around the globe and the increasing utilization of storage capacity. Despite strong refinery demand for crude oil and strong consumer demand for gasoline, the price elasticity of demand has not been enough to offset the glut of supply. Coupled with the potential for a stronger U.S. dollar this year and OPEC’s desire to increase market share, it translates into a very slow rebalancing process. When commodity markets are oversupplied and inventory levels are high, the adjustment level must come from price—and that signals to us continued downside at least for the first half of 2016.
A Rolling Loan Gathers No Loss…Until It Stops Rolling: How A Lack Of Liquidity Spreads The Credit Cycle
All credit cycles begin with concentrated risks—last cycle it was housing, the one before that was telecom, media and technology. When the concentration of credit risk is big enough, the spillover effects of default losses are hard to contain. With one-third of all High Yield debt issuance since 2010 and one-third of all EM corporate debt outstanding coming from Energy, Metals and Mining, today’s concentrated risks are certainly big enough.
And liquidity—or the lack thereof—is the reason why the concerns in credit are not limited to these commodity related sectors. When considering the fundamental cause of default it is always liquidity, summarized by one of our all time favorite themes, A Rolling Loan Gathers No Loss. When default risk spikes in one sector it leads to a withdrawal of liquidity in other potentially vulnerable sectors and issuers.
Beware Of Bifurcation
Do those nearly 9% high yields look attractive? Look a bit closer and you will see they do not exist. That average yield reflects a bifurcated credit market: 6% yields in the “safe stuff” but closer to 12% in sectors with real default risk. The bifurcation of credit markets are again telling you that the withdrawal of liquidity (aka credit rationing) is exactly what is happening. Consider that in 2015 CCC credit in HY fell more than 12% while BBs lost only 1%. While outflows remained benign, fears of outflows led to this rationing of credit.
We see a similar bifurcation in the bank loan market. While the index average fell around 8 points in 2015 to $88, the bottom 20% of the market accounted for almost all of the decline. When liquidity leaves the most vulnerable issues in search of the safest, the perceived safe issuers’ prices can stay stable and today average around $98. But for the bottom 20%—the risky stuff—their prices dropped to an average of around $60. Were liquidity to further withdraw from the market, that $98 average price segment is most at risk.
It is exactly this withdrawal of liquidity from the highest risk issuers that causes the spread of the credit cycle from its initial sectoral concentration. No wonder that historically across the default cycle, half of all defaults come from the CCC sector. When default risks rose in one sector they spread to others through this rationing of credit. And issuers with the most dependence on liquidity for rolling over their debts and funding negative working capital—CCC-rated issuers— end up contributing most to the default outcome.
From Virtuous To Vicious Liquidity: Cognitive Biases Of The Credit Cycle
The ebb and flow of liquidity fueling the credit cycle stems from three fundamental cognitive biases: anchoring, failure of imagination and loss aversion. Anchoring bias—the tendency to use an initial piece of information when making subsequent judgements—contributes to “reaching for yield” behavior that brings a wave of investors’ liquidity in the mid- to late-credit cycle. At this point in the credit cycle yields are still relatively high, but as the credit quality of the surviving universe of credits improves (both as a function of having defaulted or restructured the weakest parts of the market and as a function of improvements in the business cycle) more liquidity coming into the market improves the refinancing capability of companies. This further reduces default risk and further improves credit profiles. In this virtuous part of the credit cycle, liquidity and default risk all reinforce each other to lower defaults and tighter credit spreads. Anchoring bias contributes to investors’ belief that the virtuous liquidity cycle will always be the case. This is best illustrated by the consensus view typically found in the middle of the credit cycle of protracted low 2% default rate expectations.