The remarkable and well-documented rise of the shale oil phenomenon over the past few years has led oil supply growth to exceed expectations, yet growth in demand remains moderate. Meanwhile, the so-called oil intensity of economies across the globe has declined for years, but oil prices had, until recently, stayed firm in spite of weakening fundamentals. Forecasts for oil prices in the past few years didn’t recognize the possibility of a sharp decline. As recently as September 2014, the median Bloomberg consensus forecast was about $100 per barrel; the low end of the forecast was $90 (see chart 1). The steep decline that continued through the rest of 2014 shocked many. We at BlackRock thus think it’s worthwhile to ask whether signs of that price collapse were missed.
Let’s first take a look at the credit markets. Shale oil production growth required the build-out of major infrastructure, including the acquisition of acreage, and the high-yield bond market became an important source of growth capital. Total energy sector issuance in high-yield from 2010 to 2014 was about $330 billion, with bonds accounting for about 60 percent of that issuance and leveraged loans accounting for the rest. The weighting of the energy sector in the high-yield market index grew from about 11 to 17 percent over that period, and, notably, the trend in issuance through this period was weighted toward small, less-diversified and low-rated companies.
The debt component was typically composed of asset-based loans and unsecured bonds. The asset-based loans generally were secured by all of the current producing assets, whereas the unsecured bonds derived their value from future cash flows of proven undeveloped reserves. This layering of debt in effect transferred most of the risk to the bondholders. The value of the equity — the most subordinated segment of the capital structure — was distanced even farther from the current earnings and cash flows. It was based on any residual cash flows from proven undeveloped reserves and the estimated values of undeveloped 2P (proven and probable) and 3P (proven, probable and possible) reserves. Effectively, the value of the equity was determined by the management’s ability to grow production and reserves by sustained high commodity prices and by the company’s future ability to pay down debt. In other words, equity was priced like a growth option. The equity price of a leveraged company was therefore extremely sensitive to its future growth prospects — which, in turn, depended on the commodity price.
The equity prices of high-yield energy companies had started to underperform as early as July 2014 (see charts 2 and 3), and within that category, the most leveraged companies were beginning to underperform their peers — a concerning signal, to be sure. The returns on corresponding bonds were much slower to react and only began to underperform in tandem with the slide in oil prices. That equity price behavior might have been the earliest decent signal of a forthcoming collapse in the price of oil. A combination of rising capital expenditures, increasing debt issuance and falling or underperforming equity prices, along with increasing dispersion within the sector, perhaps was a good signal to underweight the sector. If nothing else, it would reduce the reliance on estimating growth in oil supply and demand or following consensus price forecasts, endeavors that we know can be difficult (in the former instance) and often misguided (in the latter). Moreover, the fact that quarterly energy-sector capex continued apace through this period — even as quarterly corporate free cash flow dropped off — is testimony to the fact that many in the industry itself did not anticipate the dramatic decline in oil prices .
We would hypothesize that similar patterns might also be found in other instances of commodity-dependent firm equities during periods around commodity price collapses. As played out a few years back in the mining sector, the equity prices of the more leveraged companies started underperforming before the drop in commodity prices, whereas the debt markets remained accommodative and consensus commodity price forecasts remained high. Fascinatingly, the present equity price indicator suggests that the underlying commodities prices of the metals and mining and natural gas sectors are likely to remain weak in the near term. Analyses of this kind deal with many uncertainties. But one can wonder if the highly accommodative monetary policy of developed-markets central banks might have muted bond market early-warning signals, while equity-market price signals appeared to better highlight the risks.
Adi Behari is a member of the model-based fixed-income portfolio management team at BlackRock in San Francisco.
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