Early last month, we showed you a chart that “made no sense.”
See how the light blue line (WTI inverted) has decoupled materially from the dark blue line on all kinds of occasions since last year’s deflationary doldrums?
Yeah, well basically what those disconnects mean is that HY E&P names weren’t underperforming HY as a whole when crude prices fell sharply (again, the right scale is inverted).
Clearly, that makes no sense. E&P spreads should blow out far more than HY as a whole when crude falls, for obvious reasons. Here’s what we said last month:
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.
Needless to say, we’re not “in the camp” that’s buying the “leaner and meaner” thesis, which led us to summarize the situation as follows:
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.
Well, fast forward six weeks and Goldman is hell-bent on explaining away a similar discrepancy with what amounts to the same “leaner and meaner” excuse. Here’s HY energy vs. HY as a whole plotted with crude and also with energy equities vs. the S&P:
Usually when credit and equities are saying two completely different things credit is correct. This time is an exception. Here’s Goldman’s rationale:
In advance of the scheduled May 25 meeting of OPEC members, Saudi Arabia and Russia announced today, May 15, that they had reached an agreement to extend their oil output cuts for another nine months through March 2018. Our commodities team indicated this increases the likelihood that all OPEC participants will agree to such an extension as well. Our team continues to believe near-term fundamentals will continue to show steady draws in OECD inventories in the short term, and that prices will remain in a $45-55/bbl long-term range. They forecast Brent at $57/bbl and backwardation in the oil market in 3Q17.
This news has come against a diverging backdrop of oil-exposed assets. Since the start of the year, energy equities have performed quite poorly relative to the market, although energy credits have held up well against the broader credit market (Exhibit 1 plots this for the US). Our credit team has emphasised that US HY energy has held up well primarily because of three reasons: (1) bond investors are more focused on production costs and efficiency gains, while the decline in longer-dated prices pose more risks to equity earnings growth, (2) energy credit quality is in a better place after the defaults of last year, and (3) refinancing risk remains low. In the energy space we prefer credit to equity at this juncture. Our European single stock oil analysts have argued that a correction in high yield financing may be needed to contain US shale oil growth – until then pressure on LT oil prices continue, which is likely to weigh on energy equities.\
To be clear, we don’t give a shit one way or the other what Goldman “prefers” in terms of credit versus equities.
Rather, our contention is that credit isn’t pricing this properly. HY energy is, like the rest of HY, priced to perfection and the fact that energy spreads aren’t blowing out relative to HY spreads as a whole when oil craters certainly suggests that if HY is priced to perfection, HY energy is “priced to perfection-er-er-er.”