‘The Risk Has Risen’: When Will Oil Prices Matter For Junk?

Crude took a rather precipitous dive on Friday in the wake of a veritable gut punch from PetroLogistics, who said OPEC supply in July is expected to exceed 33 million barrels a day. That would be the highest since December 2016.

That rather unfortunate (if you’re a bull) development undercut what was otherwise a half-decent week that saw another batch of ostensibly bullish data (rising production notwithstanding) and more hints that the Saudis are getting serious about propping up prices.

As you can see, the price action on Friday underscored the notion that this market is looking for excuses to sell off and still suffers from an acute crisis of confidence:

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Meanwhile, investors are still asking the same question: at what point do jitters about crude and attendant widening in energy spreads spill over into the larger HY market?

This is a subject we’ve covered extensively in these pages and one particularly interesting thing to note is that this appears to be a rare case where credit is lagging equities in terms of pricing in reality.

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And while credit has indeed remained resilient, the most recent downturn in crude wasn’t digested as well by HY Energy names and that validated something we said way back in January: namely that the notion that HY Energy should trade inside of HY as a whole was patently absurd given the backdrop.

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(Citi)

You can trace that amusing story back to its origin starting here.

On this score, Goldman notes that “for HY Energy credits, the recent gyration in oil prices carried a slightly different flavor [as] unlike previous episodes of volatility in the crude market, the relative performance of HY Energy credits vs. the broader HY market has turned somewhat more responsive to the performance of crude.”

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Ok, so that gets us back to the original question about when this will spill over into the broader HY market. Here is Goldman’s answer:

When will HY start to care about oil?

The recent price action in the oil market and the stronger response of the HY Energy sector has prompted many market participants to question the ability of the broader HY market to continue to resist lower oil prices. In our view, the bar remains high for oil prices to become the main directional driver of HY spreads but the risk has risen.

One way to quantify this risk is to examine any potential asymmetry in the way the HY market responds to moves in oil prices. Exhibit 4 takes this into perspective and depicts the response of HY weekly total returns (ex-Energy) to weekly crude price returns since the onset of the New Oil Order in 2014. The left panel shows the impact of negative oil price returns while the right panel shows the response to positive oil price returns. The key message from Exhibit 4 is twofold. First, the response of the HY market to moves in crude is asymmetric. The impact of negative oil price returns on HY ex-Energy total returns is nearly double that of positive oil price returns. Second, taking the simple univariate regressions shown in Exhibit 4 at face value suggests a 20% decline in oil prices to sub-$40/bbl would cause HY ex-Energy total returns to decline by 2%. This estimate is obviously subject to uncertainty and the risk of a large decline in oil prices remains low. But as our commodities team discussed recently, data volatility continues to impact sentiment which renders the risk of large higher or lower moves in the short-term symmetrical.

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Right, so that’s a lot of math and numbers. Math is hard, and numbers are boring, which means math plus numbers (and you really can’t have one without the other) is both hard and boring.

So just note the bit about how negative oil price shocks matter more than positive price shocks.

Finally, for those interested in Citi’s take, here are some neat slides that we’ve been saving for just the right time…

Via Citi

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