the weekly orb - the real problem with the decline in oil prices

8/10/2019 The Weekly Orb - The Real Problem With The Decline In Oil Prices

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The Weekly Orb: The Real Problem With The Decline in Oil Prices

There is zero evidence that the recent decline in oil prices will have a negative impact on the US economy

as a whole. Certainly the decline in oil prices will impact Lubbock, South Texas, and probably Houston -

but for the US as a whole, no impact.

If you are going to dispute this assertion, please bring some actual data which includes something besides"my company is going to lay off X people".

The chart below from Cornerstone Macro is the overwhelming consensus opinion on how the decline in oil

prices impacts various countries and economic regions. Notice how the US is listed on theGoodside.

However just because lower oil prices won't be a negative for the economy as a whole does not mean that

lower oil prices will not create a problem.

The real problem in the US with the decline in oil prices is that it sets up the strong likelihood for a credit

bust somewhere. A credit bust happens when either the entire bond market or a segment of the bond

market declines sufficiently enough in price that it causes some entity to go bankrupt or almost

bankrupt. Where the danger of a credit bust resides is often times quite a surprise.

Here are two examples of prior credit busts.

In 1994 the FED started on a tightening cycle. The yield on the 10 year went from around 5.3% to a little

over 8%. Whenever there are such large moves in the credit market it is an axiom that there will be a

credit bust someplace. What the surprise was in 1994 was that it happened to be Orange County that

went bankrupt - red arrow marks the OC bankruptcy.


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Over 1997 & 1998 oil prices decline some 50%. The decline in oil prices caused a run on the Ruble which

resulted in Russia defaulting on its bonds. When Russia defaulted on its bonds, global investors sold.

Emerging Market debt and rushed into US Treasuries for safety.

Unfortunately this happened just as Long Term Capital Management happened to be long EM debt and

short Treasure debt and they were leveraged out the wazoo on this trade. The FED had to step in and

conduct a liquidation of LTCM to keep the financial markets from falling apart. Red arrow marks the LTCM

bankruptcy.

Where credit risk lies is very unpredictable. What is known is that the risks for a credit bust are high

when either the bond market or a segment of the bond market has a major decline in price.

The fracking boom in the US has largely happened on borrowed money. Over the last 10 years there has

been a steady increase in the percentage of bonds issued in the high yield space by energy

companies. Small exploration companies are just the kind of companies that fall into this category. The

majors are not junk credits.

When these loans were originated I am very sure that the assumption was that oil prices would stay

above a certain price. A good guess on the floor price for oil would probably be in the $70 to $75 dollar

range. At prices below this much of this debt is not solvent.


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Junk debt (below investment grade debt) comes in levels of riskiness from BB down to single C. Various

junk bond ETFs have been issued that track various categories of junk bonds and there is one that tracks

the single B index. That ETF is the Peritus High Yield ETF, symbol HYLD. The industry breakdown for

HYLD is below. Some 25% of HYLD is allocated to oil with 15% specifically in oil exploration and

production. What this means is that a very large proportion of the entire junk bond market is tied to one

very specific industry, the oil industry.

The chart covers the last 6 months and shows the price of HYLD (black line) and the price of Light Sweet

Crude (red line). The correspondence is as close to one to one as your are going to get. Which means

that as crude oil prices have fallen investors have sold off HYLD because the likelihood of bond defaults

from oil sector bonds has risen.


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This is not just impacting ETFs. The paragraph below is from a story in the Financial Times a few days

ago.

Even the banking industry is starting to smart from some Energy loansdone at the peak. Will banks be able to absorb what they have

underwritten? This will be another headwind for bank/financial stocks and

their ETFs in addition to the flattening yield curveNow banks are also being affected, with Barclays and Wells said to face potential losses on an energy-related loan. Earlier this year,

the two banks led an $850m "bridge loan" to help fund the merger of Sabine Oil & Gas and Forest Oil, U.S.-based oil companies.

Investors, however, balked at buying the loan when it was first offered in June and slumping oil prices combined with volatile credit

markets in the months since have scuppered further attempts to sell, or syndicate, the loan, according to market participants. Barclays

and Wells declined to comment. With underwriting banks unable to offload the loan to investors, they are now facing losses on the

deal as the value of the two oil companies' debt erodes. Sabine's bonds were trading above their face value at around $105.25 in June,

but have since fallen to $94.25 - firmly in "distressed" territory. Their yield - which moves inversely to price - has jumped fromaround 7.05 per cent to 13.4 per cent. Rival bankers estimate that if Barclays and Wells attempted to syndicate the $850m loan now, it

could go for as little as 60 cents on the dollar.

This decline in the price of high yield bonds in general and the single B segment in particular is happening

at the exact same time as two other important components.

First, there are a lot of income tourists in the junk bond space who just reached for yield and have no idea

what they own.

The chart below takes a little time to decipher. The red line is the yield on the 10 year Treasury on aninverted basis. Red line high, yield on the 10 year Treasury low. The black line is the percentage of all

corporate bonds that are held by households (retail investors primarily through mutual funds and

ETFs). As yields in the Treasury market have come down, the percentage of the corporate bond market

held by households has increased from around 13% of all corporate bonds to almost 30% of all corporate

bonds. Retail money is not sticky money and it tends to sell out when prices start to go down.


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Second, this decline is happening when the total debit balances (investors trading on borrowed money) is

at an all-time high.

The red bars indicate the level on debit balances. The blue line is the S&P 500 on an inverted scale. The

largest amount of margin is always broadly associated with market tops.

Junk bonds are priced off a spread to treasuries. A spread is simply how much the yield difference is

between two different bonds and it is expressed in basis points. One hundred basis points is equal to onepercentage point.

The chart below is of the spread of the single B segment of the junk bond market to Treasuries. Spreads

troughed at very low levels in June 2014 and have since been on the rise as the single B segment of the

junk bond market has fallen in price. (As bond prices fall the current yield increases, which widens the

spread to Treasuries.)


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The next chart is of the year over year rate of change in single B spreads. Notice that the year over year

rate of change in spreads has gone positive. That means that spreads today are wider than they were a

year ago.

Now, here is where it gets really interesting.

In the chart below the year over year rate of change in single B spreads (blue line) is overlaid with the

year over year rate of change in the VIX (red line). The VIX is a measure of stock market

volatility. When the stock market goes down, the VIX goes up.

The correspondence between the two series is unusually close.

In simple terms you might state it this way: When junk bond prices go down (an especially the single B

segment) the VIX tends to go up, which means that stock prices have gone down.

Now, so far stock investors have completely ignored the decline in junk bond prices.

If oil prices continue to decline, then junk bond prices will continue to decline given how large oil issues

have become in the junk bond space. In oil prices continue to decline and stay down then there will be


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some issuers that will go bankrupt. Whenever a segment of the bond market declines there is a credit

bust someplace and that someplace is often times very unexpected.

Lower oil prices mean lower junk bond prices. Lower junk bond prices set up a credit bust to happen

someplace. This is happening when there are a large number of income tourists in the corporate bond

space and margin is at an all-time high. Widening spreads are associated with a higher VIX. A higher VIX

is associated with lower stock prices.

The trigger for the stock market correction that I have been looking for is getting pulled.

the weekly orb - the real problem with the decline in oil prices

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