As Oil Rises (Back) Above $50, One Question Remains

Here we go again.

As you’re probably aware, oil was up on Thursday for absolutely no reason. Well, maybe we shouldn’t be so blunt, but as some other folks correctly noted this afternoon, we didn’t learn anything today that we didn’t already know. Here’s Bloomberg:

• WTI climbs above $50 for first time in almost 3 weeks. Kuwait and other countries support extending OPEC cuts, KUNA reports. Libya’s oil output said to fall to 6-month low.
• “It certainly doesn’t hurt the market to have broad support for cut renewals in addition to good reported deal compliance for March,” Clayton Rogers, an energy derivative broker at SCS Commodities Corp. in Jersey City, New Jersey, says by message
• “We also have recent supply issues in Libya and Iraq making life difficult for some of the new fund short positions in the market”

So…. it’s possible that the cuts will be extended. Again, nothing new. “Nevertheless, the bulls persisted” (there’s a ‘Liz Warren joke in there)…

You’ll recall that one of the points we’ve been pretty keen on making with regard to high yield and oil is that the last time spreads were as tight as they are now, crude was hovering at ~$90/bbl. That would seem to suggest that HY is far too rich.

The counterargument is that US operators are leaner and more efficient now, which means there’s some justification for tighter spreads at lower crude prices.

Well, we’re not really buying that argument, but in case you are, you might find the following from Barclays to be of interest – particularly given the fact that $50/bbl has such a nice (psychological) ring to it…

Via Barclays

High Yield Oil Field Services — Historical Yield to Worst versus Oil

We believe that oil service companies are now far leaner and better prepared for a prolonged sub-$50/bbl price scenario if or when it occurs. Having said that, at a sustained price of $45/bbl, we estimate that EBITDA for the US services/equipment subsector would be closer to breakeven. Below $45/bbl, North American service margins could roll back into negative territory. For offshore drilling credits, a stable $50/bbl price is needed to avoid increases in net debt (revolver draws and cash burn). Around $45/bbl, offshore drilling credits could start to experience a considerable amount of financial distress, but only if operators believe prices are sustainable at those levels.

In early February 2015, when oil prices recovered to $48/bbl (close to current levels), from the mid-40s in January 2015, the Bloomberg Barclays high yield oil field services index was trading at a yield to worst of 12.3%, compared with the current 8.2%. So how could the same oil price as today lead to a 410bp tighter index?

We believe the answer is related to operational improvements and a perceived light at the end of the tunnel for upstream spending growth, as well as a more sustainable oil price above $50/bbl. In addition:

• Costs per barrel have declined about 40%, helping to lower breakevens materially and improve netbacks. This has helped upstream spending in core areas of the Permian and Eagle Ford to increase sooner.
• Since January 2016, almost $40bn in equity has been raised for the energy sector. Operators are better capitalized, and counterparty risk has been reduced.
• Debt markets have helped companies extend maturities, pushing out capital commitments.
• OPEC cuts have provided tangible or psychological put options for oil price (for now).
• Global demand for oil is expected to exceed supply in 2017 for the first time in three years.
• Natural gas prices have recovered 20%, and the startup on the Sabine Pass LNG facility provides producers with long-term and stable export growth that Barclays estimates can increase from almost nothing a year ago to nearly 8bcf/d by summer 2020.

At the end of the day, the question remains: is this sector “leaner and meaner” enough to justify current richness?