‘Does This Train Have Any Brakes?!’ Goldman Slashes HY Energy

Ok, so we’ve written tirelessly about the self-defeating dynamic at play in the US energy complex and I don’t think we need to launch into a long-winded recap of our thesis here.

The bottom line is that at some point, the bond market has to take the keys away (i.e. spreads are going to need to widen materially) or the folks Anadarko boss Al Walker recently referred to as a bunch of hopeless alcoholics are going to keep on drilling and keep on issuing debt.

This is exacerbated by the fact that, as WSJ wrote a while back, “most of their management teams are paid based on growth or adding new oil and gas reserves—not on profits.”

Here’s what Goldman wrote a couple of weeks ago:

The arithmetic average yield of benchmark bonds for all covered E&Ps is 5% (excluding CRC, DNR, and EPE, 6% when including these three companies). We believe this may not send a requisite message to rein in drilling activity for all producers. On the flip side, it sends a theoretical message for producers to issue more debt.

Right.

On Monday, Anadarko became the first US producer to cut spending, a move that may or may not encourage others to follow suit, depending on how markets react. We talked about this at length earlier today and for those who want a quick summary, here’s Reuters:

Anadarko and the rest of the U.S. shale oil industry have been grappling with how to conserve cash and maintain growth opportunities even as crude prices have slumped since January.

Many Wall Street analysts had asked U.S. producers to consider cutting budgets, and it was unclear which company would do so first. Anadarko, the first major U.S. producer to report quarterly results, ended that guessing game.

But again, all of this kind of depends on the extent to which investors exhibit some semblance of discipline in how the treat companies that aren’t acting responsibly, and in a world where yield is hard to come by and in an environment where HY Energy spreads have remained largely resilient (until very recently) to negative oil price shocks, it’s tempting for folks to stick around until a negative catalyst is immediately apparent. Of course by then it’s too fucking late.

Well with that as the backdrop, consider the following highly amusing bit out from Goldman, excerpted from a note in which the bank cuts their view on HY energy…

Via Goldman

Does this train have any brakes?

Producer activity at <$50 oil continues to outstrip our expectations. Evidence from E&Ps suggests that a sustained period of <$45 WTI – combined with an increase in HY funding costs – will be required to generate the needed deceleration in activity.

Accordingly, we are lowering our coverage view to Neutral from Attractive and changing 7 ratings.

While it has become consensus that the US rig count needs to inflect, HY Energy has actually tightened by 36bp (-17bp vs. market) since 7/10 on the back of WTI recovering to $47/bbl from $42. In investor conversations, many acknowledge the unstable foundation of the rally, but believe they will be able de-risk when conditions begin to reverse. However history has shown that attempting this type of timing has rarely succeeded.

GSCrude

Currently there are 950 land rigs drilling in the US, +292 (+44%) from 12/31/16. At the current rig count, we believe US oil production is poised to grow by >800k b/d in 2018, which is likely to result in an again oversupplied oil market. With the oil market looking over the precipice at a production surplus, we find ourselves again asking the question “how do you slow shale?”

As we’ve argued, we continue to view the US high yield market as an important governor on the pace of US shale production growth. Around 2mm b/d of US oil production (22%) depend on high yield funding for growth, and, consequently, we believe higher funding costs are an important mechanism for slowing growth. Our models suggest that each 100bp of funding cost increase reduces 2018 oil growth by about ~100k b/d. We note that the term structure of HY maturities (shown below) somewhat slows the pace at which higher funding costs are likely to change producer behavior.

GSHY2

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