In Chaos theory, a Hopf Bifurcation is the critical point where a system’s stability switches into a periodic solution (chaotic dynamic). This feels markedly like the events which transpired on Monday. There is an obvious fear of contagion swirling around the market. The discount on the price move is like the cascades experienced on October 15, 2008. The volatility index jumped 38% at open to 62. A historic washout level that’s only been seen during times of immediate and critical stress. The question we must ask ourselves moving forward is are we at a time of clear and present danger? For that we need to understand the drivers of fear in the marketplace, coronavirus and oil.
Oil Sector Impairment: Key Risks
– Industrial Employment
– Distressed Loans
– Geo-political friction
– Employment Drag
Sunday evening Saudi Arabia announced an increase in production of 10mm/bpd for April, moving from 9.7mm/bpd to 19.7mm/bpd. This increase in production equates to a price decline of between $6-8$ per barrel. This prompted OPEC to remove restrictions on its own production prompting speculation of an immediate price war in crude markets. This supply imbalance coupled with IAE reports over the weekend concluded a demand contraction in 2020 began the spiral of events that bled over into risky asset markets.
The ensuing price collapse prompted many market participants to equivocate oil as a proxy for demand destruction in the broader economy. The interesting dynamic, however, is how little exposure the S&P500 has to energy within their constituent components. As of 12/31 2019, energy represented 4.35% of the total index.
The impact however is seen in US GDP with the energy sector accounting for an approximate 8% contribution and responsible for employing 10.3 million jobs (API). Not an overly excessive amount, but for an economy at full employment, stress on oil production could force broader constituents of the crude ecosystem to be in danger of losing their employment status, which will add marginal friction to growth tailwinds.
The current footing of Saudi Arabia is basically one of economic warfare on higher cost producing nations. They have decided to push additional supply in order to remove competitors and increase their global wallet share in the hope they can recoup OPEC’s dominance as an organization in the age of non-conventional producers like the US and Russia.
This move might bring about increasing tension between OPEC nations, including Iran, Iraq and Syria as well OPEC+ members such as Russia. It goes to how long losses can be sustained before Saudi Arabia decides to be a rational actor. Aramco’s “flow of funds” per barrel is $26, they are losing money at current levels. (Reuters)
This is compounded by an inability to gain access to additional working capital for production and to debt servicing. The Industry average working capital ratio as of Dec 31, 2019 is 0.87. A problem for the US oil industry is the average breakeven price of production remains around $48 (Statista). With oil prices falling to $31.13, every 1 dollar spent on production now returns 46 cents. This will lead to supply rationalization in the United States and lower employment. Decreased production will limit cashflows to service debt placing the sector in a precarious position moving forward and risk restructuring, losses within the financial service industry.
Distressed Loans: The bankruptcies are coming
Chesapeake Energy Corp stock traded below 22 cents on Monday with many traders anticipating the debt load will become too burdensome to manage with oil prices at current levels. There are many others in a similar position. US High Yield exposure spreads have begun to widen relative to treasuries with 5-year HY CDS spreads pricing in a default probability of 22.9%, this number rises if you just look at energy companies.
The recent price action in oil and high yield bonds led to a slew of sector downgrades yesterday. Bank of America placed almost the entire complex on sell, with 1 buy, 7 neutrals and 16 underperforms. However, they did note that the survivors of this dislocation period will structurally see better returns in the future as competitors drop out of the market.