We’ve talked a ton in these pages about HY energy and the extent to which the massive spread compression off 2016’s deflationary doldrums is probably way – way – overdone considering where oil prices were the last time spreads were as tight as they are now.
For the latest on this, see “As Oil Rises (Back) Above $50, One Question Remains.”
Well it’s Sunday afternoon, so we aren’t going to make you think too hard, but we did want to highlight yet another chart which demonstrates the extent to which energy credit seems completely disconnected from energy (read: oil) reality. Have a look at this:
(Goldman)
So that’s HY E&P spreads vs. HY overall (dark blue, lhs) plotted with oil prices.
In the simplest possible terms, that dark blue line should move higher when oil prices fall (note the right-hand side is inverted). Why? Well, because again, that’s the ratio of HY E&P spreads to the HY market overall. The more bearish the outlook for crude, the wider HY E&P spreads should be versus overall HY spreads and thus the higher the ratio.
Those glaring disconnects you see (the one that persists today and the multiple other instances of the same discrepancy that are readily apparent during 2016) are indicative of mispricings – unless of course you’re in the camp that believes US operators are so much “leaner and meaner” that a 50% decline in oil prices is no big deal.
Here’s Goldman with some color:
Compared with the significant decline in WTI oil prices, HY E&Ps saw only a modest widening in the ratio between HY E&P spreads and the HY market overall (Exhibit 1). The resilience of E&P spreads should not come as a surprise given the spread ratio between HY E&Ps and the broad HY index also saw very mild reactions when WTI prices posted declines in excess of 15% at two other points last year, also shown in Exhibit 1.
Why have HY E&P credits resisted relatively large oil price declines? For one, the quality of the sector composition has improved compared with 2015, especially after the flushing of uncompetitive, high-cost HY E&Ps last year when the default rate soared to record highs. Additionally, the short-cycle nature of shale producers combined with a more developed hedging market has enhanced the certainty of cash flows, and left investors more comfortable with higher levels of leverage in the sector.
What. The. F*ck. Ever.
There is no way you’re going to convince us that E&P spreads shouldn’t be blowing out relative to HY as a whole when oil prices plunge. We don’t care how much more “efficient” these companies have become.
OK, but low crude prides support the economy, all else equal.