(Bloomberg) – The commodity-price slump and the slowdown in China’s economy are crippling developing nations’ ability to borrow abroad, even as international debt sales from advanced nations remain at a five-year high.
Issuance by emerging-market borrowers slumped to a net $1.5 billion in the third quarter, a drop of 98 percent from the second quarter, according to the Bank for International Settlements. That was the biggest downtrend since the 2008 financial crisis and reduced global sales of securities by almost 80 percent, the BIS said in a report.
Emerging-market assets tumbled in the third quarter, led by the biggest plunge in commodity prices since 2008 and China’s surprise devaluation of the yuan. The average yield on developing-nation corporate bonds posted the biggest increase in four years, stocks lost a combined $4.2 trillion and a gauge of currencies slid 8.3 percent against the dollar. Sanctions on Russian entities and political turmoil in Brazil and Turkey also affected sales by companies in those countries.
(CNBC) – After years of safely reaching for yield through risky assets like stocks and speculative-grade bonds, Wall Street is heading into 2016 rethinking the strategy.
That trend of low defaults has begun to turn the other way, with the trailing 12-month rate rising to 2.8 percent in November, the highest level in three years, according to ratings agency S&P, which expects defaults to climb to 3.3 percent by Sept. 30, 2016.
Moreover, fellow ratings agency Moody’s reported its liquidity stress index in November hit its highest rate since February 2010. Still more troubling is that some of the damage has begun to spill outside the oil, gas and mining sectors, where most of the defaults had been contained.
Fully one-third of oil and gas and mining and metals companies in Moody’s coverage universe are on review for downgrade or have negative outlooks.
(Bloomberg) – Amid Brazil’s economic and political tumult, the nation’s businesses have seen a record number of downgrades this year — and the total is about to get worse.
Fitch Ratings estimates it may slash the ratings of as many as 10 companies for every one it upgrades in 2016. Fitch said that grim scenario is most likely if it chops Brazil’s grade, an ever-growing possibility as the country’s woes deepen.
A top lawmaker initiated impeachment proceedings against President Dilma Rousseff last week, a move that may further undermine the nation’s finances and exacerbate the worst recession in a quarter century. That spells trouble for companies already finding it hard to obtain financing in the wake of an unprecedented corruption scandal at Brazil’s state oil company.
“You will see companies burning cash,” Fitch’s Carvalho said. “The cross-border market is closed for Brazilian companies, and the local market is selective.”
(CNBC) – If Saudi Arabia maintains oil production at current levels amid the oil price crash, then it’s going to have to cut its budget — or it will likely be bankrupt by the end of the decade. The big issue is Saudi Arabia’s big spending ways, especially increased government spending on social welfare programs.
According to the IMF, government expenditures in Saudi Arabia are expected to reach 50.4 percent of GDP in 2015, up from 40.8 percent in 2014. That increase can be attributed to two things: falling oil prices (it’s bringing in less revenue) and an inflated budget (it’s spending more money).
It’s no secret that a large portion of Saudi Arabia’s roughly 30 million people rely on the government for economic support. In February, the newly crowned King Salman doled out a reported $32 billion to the Saudi people in bonuses and subsidies to celebrate his ascension to the throne.
“We are a welfare society, so the population depends a lot on government subsidies, directly and indirectly,” Abdullah Al-Alami, a Saudi writer and economist, recently told The New York Times. “But one day we are going to run out of oil, and I don’t believe it is wise to be pampered and subsidized.”
To summarize, the world is entering a classic credit crunch, in which lending dries up for marginal borrowers first before tightening for core entities like multinational corporations and developed world governments. And it’s just beginning.
Most of today’s crises evolved with oil considerably higher and the dollar somewhat lower, so current conditions are actually a lot worse than those that, for instance, caused emerging market debt issuance to evaporate and shoved Brazil into existential crisis.
And since oil overproduction will likely to continue while the differences in central bank policies are etched in stone for the next few months at least, it’s possible that the performance gap between oil and the dollar will widen going forward. This will turbo-charge today’s crises and add a few more, as oil producing US states hit financial walls and big chunks of the developing world follow Brazil down the drain.
MACRO News Items of Importance - This Week
GLOBAL MACRO REPORTS & ANALYSIS
US ECONOMIC REPORTS & ANALYSIS
CENTRAL BANKING MONETARY POLICIES, ACTIONS & ACTIVITIES
Global equity markets, as measured by the MSCI Developed World index, are above the lows hit in early October but remain on a downtrend that began after markets peaked at the end of May this year.
As SocGen's Andrew Lapthorne notes, the current level is now only just above where the index stood at the beginning of 2013 and less than 1% above the 2007 peak. In other words, as he warns, "the equity market has run out of momentum," and the 'bill' for the debt overhang is coming due.
The recovery since 2007 has been very one-sided with only Denmark, Switzerland and the US indices exceeding their October 2007 US dollar price levels.
The UK is down 34% in US dollar terms and the MSCI Eurozone is 40% down. The reasons for this weak performance is fairly clear, unlike Japan neither the UK or Eurozone have experienced an earnings recovery in either US dollar terms or in local currency terms. Profits in both regions are still 45-55% down from the 2007 high according to MSCI reported profits.
The Eurozone of course has many problems, but at least Eurozone companies have not been boosting leverage as a consequence of disappointing profits, as is the case in the US and apparently the UK as well! As we have remarked upon on numerous occasions, the US equity market has been boosting leverage with record levels of debt-financed share buybacks, resulting in a significant increase in leverage among US corporates.
However with all the focus on the US, many investors may have missed the major corporate debt problem now emerging in the UK stock market. Devoid of the headline-grabbing buybacks, many may not have noticed that both nominal net debt and net debt to EBITDA have never been higher in the UK.
The bulk of that increase has come from a huge rise in Mining sector debt at a time when profits have collapsed, but leverage ratios in other sectors are also elevated. The US is not the only market now facing a corporate debt overhang.
COMMODITY CORNER - AGRI-COMPLEX
THESIS - Mondays Posts on Financial Repression & Posts on Thursday as Key Updates Occur
FRA Co-Founder Gordon T. Long interviews Brett Rentmeester on Austrian economics and the importance of having an entrepreneurial mindset in investment. Brent Rentmeester is the president of Windrock Wealth Management and has been in the wealth asset management for over 18years. Mr Rentmeester believes the uniqueness of Windrock is its focus on the macroeconomic picture, Austrian economics and what it all means for investment implications as well as an entrepreneurial mindset on how to find investment opportunities.
The Austrian school to him is the “acknowledgement of the influence that central banks have on the business cycle and interest rate and therefore the opportunities left for investment”.
He mentions that the traditional stock, bond portfolio is under a lot of challenge going forward because there is no real and safe income anywhere today. As a result people are becoming speculators and risk takers even when they don’t want to.
Brett believes having an entrepreneur mindset when investing, is the key to addressing the dilemma of income and the future of investment. Secure private lending is lending money to borrowers that is backed by real tangible assets or an income stream. According to him, what makes this a unique category is that it addresses the pockets of lending that is being neglected by the big banks as a result of the financial banking distress that took place in 2008.
On examples of secure private lending, Brett highlights 3 different categories with his examples. He explains that in auctioned rental properties, the government organizations Fannie Mae and Freddie Mac by law are restricted from buying mortgages on such properties until after 2 years, this results in a niche market for private lenders. “In energy markets more states are moving towards a deregulated market”. What this means is that a consumer can buy energy from a variety of energy companies. Now this system is facilitated by third party brokers who go door to door offering this energy from various energy companies. Now because the brokers want the commissions up front and the energy companies can’t provide it, we see people coming in to pay the brokers a discounted fee upfront and then agree to collect the 3year contract provided by the energy companies.
“Global trade happens between different parties but often times it’s financed by big banks, trade receivables. So one party needs to buy goods and a supplier supplies them but someone’s got to finance that transaction and it’s often the third party bank”.
Due to new regulations, banks are required to reserve more capital in such situations, as a result an opportunity is created for private money to finance the transaction between the customer and supplier.
“Rather than taking on more risk you don’t have to today, you just have to be more creative”
– Gordon. T. Long.
Brett echoes this sentiment saying:
“So much of the industry and investors think in a very narrow box of stocks, bonds and maybe hedge funds but there’s a lot of things outside of that, that if you open your mind to the opportunities, are quite interesting to research”.
Back in 1971, about 2 out of 3 Americans lived in middle-income households. Since then, the middle has been steadily shrinking.
Today, just a shade under half of all households (about 49.9 percent) have middle incomes. Slightly more than half of Americans (about 50.1 percent) either live in a lower-class household (roughly 29 percent) or an upper-class household (about 21 percent).
As NPR explains, thanks to factory closings and other economic factors, the country now has 120.8 million adults living in middle-income households, the study found. That compares with the 121.3 million who are living in either upper- or lower-income households.
"The hollowing of the middle has proceeded steadily for the past four decades," Pew concluded.
And middle-income Americans not only have shrunk as a share of the population but have fallen further behind financially, with their median income down 4 percent compared with the year 2000, Pew said.
And if you’re a millennial, you’d be forgiven for being disillusioned with the American dream.As we recently noted, compared to young Americans in 1986, you’re three times as likely to think the American dream is dead and buried. As WaPo notes, "young workers today are significantly more pessimistic about the possibility of success in America than their counterparts were in 1986, according to a new Fusion 2016 Issues poll - a shift that appears to reflect lingering damage from the Great Recession and more than a decade of wage stagnation for typical workers.”
It is only a matter of time before the middle class is wiped out and America begins to resemble the poverty, violence and tyranny so often associated with the countries from which many illegal migrants originate.
It appears that time is drawing near as Charles Hugh-Smith recently noted, the mainstream is finally waking up to the future of the American Dream: downward mobility for all but the top 10% of households.
Downward mobility and social defeat lead to social depression. Here are the conditions that characterize social depression:
1. High expectations of endless rising prosperity have been instilled in generations of citizens as a birthright.
2. Part-time and unemployed people are marginalized, not just financially but socially.
3. Widening income/wealth disparity as those in the top 10% pull away from the shrinking middle class.
4. A systemic decline in social/economic mobility as it becomes increasingly difficult to move from dependence on the state (welfare) or one's parents to financial independence.
5. A widening disconnect between higher education and employment: a college/university degree no longer guarantees a stable, good-paying job.
6. A failure in the Status Quo institutions and mainstream media to recognize social recession as a reality.
7. A systemic failure of imagination within state and private-sector institutions on how to address social recession issues.
8. The abandonment of middle class aspirations by the generations ensnared by the social recession: young people no longer aspire to (or cannot afford) consumerist status symbols such as luxury autos or homeownership.
9. A generational abandonment of marriage, families and independent households as these are no longer affordable to those with part-time or unstable employment, i.e. what I have termed (following Jeremy Rifkin) the end of work.
10. A loss of hope in the young generations as a result of the above conditions.
If you don't think these apply, please check back in a year. We'll have a firmer grasp of social depression in December 2016.
As Ellington pointed out, "We believe that we are now at the end of the "over-investment" phase of the corporate credit cycle in the US that has been playing out since the depths of the GFC. This view is supported by a number of telltale signs of a reversal in the credit cycle:
Worsening Fundamentals - Declining corporate prots, record levels of corporate leverage, and an elevated high yield share of total corporate debt issuance
Defaults/Downgrades - Credit rating downgrades at a pace not seen since 2009
Falling Asset Prices - Price deterioration in the lowest quality loans and the most junior CLO tranches
Tightening Lending Standards - Weak investor appetite for new distressed debt issues, declines in CLO and CCC HY bond issuance, and tightening in domestic bank lending standards
Today, the Deutsche Bank credit strategy team led by Oleg Melentyev, in its "Year-Ahead Outlook 2016" report proves beyond a doubt that not only has the credit cycle turned, but that the default cycle is at hand, initially for energy names ("a default cycle in commodity-related areas at this point is unavoidable, and the only real question here is whether it stays contained to those areas or extends itself to other sectors") and soon for most other sectors.
Here is Melentyev's unpleasant message for Yellen, who is now about to hike rates and launch a tightening cycle at precisely the time when should be easing further to take away from the pain that will be unleashed by an inevitable junk bond supernova.
The current credit cycle can be described as mature: it’s old enough, at almost five years, and extended itself far enough (55% debt growth) to be falling right in line with three cycles that came before it in the past 30 years. A widely publicized McKinsey1 study earlier this year estimated a total of new debt created since 2007 at $50trln, half of which came from EM and two-thirds from nonfinancial corporate issuers in DM and EM. Our research suggests that global debt growth rates have remained steady as a percentage of global GDP, at 64%.
A large portion of this funding went towards commodity-related projects, particularly in EM. Our own credit indexes also tell us the extent of exposure to commodities, which is roughly 40% in EM world, and close to 25% in DM. This debt was raised at a time when consensus firmly believed in the commodity super-cycle theory, which at this point we know was wrong. This leads us to believe that a default cycle in commodity-related areas at this point is unavoidable, and the only real question here is whether it stays contained to those areas or extends itself to other sectors.
Evidence we are looking at suggests there is a meaningful probability of seeing early stages of the next default cycle developing in non-commodity sectors as well. We have previously presented a set of indicators in the Evolution of the Default Cycle report in early October, suggesting that recent equity volatility spikes and a widening in highest-quality corporate spreads are potential triggers for tightening credit conditions. We further followed up in recent weeks by showing rare trends emerging in HY underperforming both equities and IG as well as CCCs underperforming BBs, both the types of market behavior usually seen around turning points in the cycle.
Behold the metastasis of the junk bond cancer:
Figure 1 below shows how distress (bonds trading over 1,000bps) has been spreading across the HY space. From its starting point in energy a year ago, it has now reached other commodity-sensitive areas such as transportation, materials, capital goods, and commercial services. But it did not stop here and is also visible in places like retail, gaming, media, consumer staples, and technology – all areas that were widely expected to be insulated from low oil prices, if not even benefitting form them.
In other words, what was until a year ago a purely "energy" phenomenon is now an "everything" phenomenon, despite promises by every prominent economist that plunging energy prices are great news for the economy. As always happens, the economists were dead wrong once again.
It gets worse:
There is another interesting aspect of the distressed environment – overall distress ratio today, at 19% of face value of overall US HY – is only modestly higher than its level at the peak of Oct 2011 selloff (17%), and is comfortably inside of EU HY distress of 35% in early 2012. So one could argue that this level in and of itself is not meaningful, given that it misfired at least twice in recent years. We do not fully agree with such an argument, as it ignores the fact that 2011 and 2012 were still in early stages of the credit cycle, but we would give it 1/2 a credit for trying.
When we change the question and ask what percent of names are in deep distress today, defined here somewhat arbitrarily as 2,000bps (dollar prices around 50pts), the answer we get is 7.1%. This level is materially higher that 2% in US HY back in Oct 2011 or 6% in EU HY back in Jan 2012.
DB is very concerned at the implications of this:
Think about the significance of this number. While some names flirt with modest levels of distress from time to time throughout the normal course of events during the expansionary phase of a cycle, many of them stage comebacks and remain current on their debt obligations. In other words, not all distressed names today will default tomorrow. To witness, the total value of unique cusips in our DM HY index that ever touched on 1,000bps since 2009 through 2014 is $600bn. The actual grand total of defaults during this time is $135bn.
For that same timeframe, $130bn of unique bonds touched on a 2,000bp level. It’s also interesting to note that peak in deep-distress ratio in Figure 2 reflects peaks in actual default rates closely (18% deep distress par vs 20% par default rate in 2002 cycle, for example). It appears that few names ever come back from the deeply distressed levels, and their prevalence in today’s environment has to be taken seriously by credit investors. Ex-energy this metric currently stands at 3.1% of index face value.
Does the credit cycle precede the business cycle or vice versa? The answer: yes.
A generic push-back we hear on this view from time to time is this: how can you be expecting tighter credit conditions and higher default pressures when US economy is doing so well? Our answer is that one does not necessarily contradict the other. We strongly believe that credit cycle leads the business cycle, and as such it is not a pre-requisite to first see a slowing economy and only then to expect tightening in credit. In fact this turn of events would be quite unusual.
The simplest proof we can provide in support of this is shown in Figure 3 below, where as some of our readers would recognize, we are repeating charts from the cycle evolution piece, showing zoomed-in versions of turns in the past three credit cycles. The grayed-out areas are marking the last 12 months before such turns, and here were are also adding a snapshot of health of the US economy, on average, during those last 12 months. Numbers speak for themselves, but both real GDP growth and non-farm payrolls remain solid and stable during these short time windows.
This is not to suggest that macro environment is irrelevant; it clearly is. But it is important to remember that a stable and solid economy alone is not sufficient to suggest that a turn in credit conditions is impossible.
Deutsche Bank's conclusion:
Overall, all this evidence continues to suggest that default pressures are likely to start accumulating during 2016 even outside of commodity sectors. We forecast ex-commodity default rate to reach 3.5% among US HY issuers, up from the current level of 1.9%. Combined with commodity producers, we are looking at 5.75% overall US HY default rate.
None of which, of course, assumes short-term rates around 1% or higher: in that case the default rate will spike proportionately as the issuance window for even the most creditworthy issuers is practically closed.
Finally, where this imminent default cycle will have unexpected downstream consequences is on the balance sheets of the debt buyers themselves: moments ago SMRA reported that according to its Money Manager Survey, portfolio managers are holding the largest percentage of corporate bonds in history, with allocations rising to 35.8%, surpassing the previous record of 35.7%, seen last week, and 35.6% 2 weeks ago.
In other words, everyone is long and strong just as the bottom is on the verge of falling out of the market.
"The US E&P sector could be on the cusp of massive defaults and bankruptcies so staggering they pose a serious threat to the US economy. Without higher oil and gas prices -- which few experts foresee in the near future -- an over-leveraged, under-hedged US E&P industry faces a truly grim 2016. How bad could things get?
"I could see a wave of defaults and bankruptcies on the scale of the telecoms, which triggered the 2001 recession."
As the crude industry has been wrestling with low oil prices that declined by over 50 percent since its highest close at $107 a barrel in 2014, many exploration and production companies worldwide and in the U.S., in particular, have faced large shortfalls in revenue and cash flow deficits forcing them to cut down on capital expenditures, drilling and forego investments in new development projects.
High debt levels taken on by the U.S. oil producers in the past to increase production while oil prices soared, have come back to haunt oil and gas companies, as some of the debt is due to mature by the end of this year, and in 2016. Times are tough for U.S. shale oil producers: Some may not make it, especially given that this month, lenders are to reassess E&P companies’ loans conditions based on their assets value in relation to the incurred debt.
Throughout the oil price upturn that lasted until the middle of 2014, companies sold shares and assets and borrowed cash to increase production and add to their reserves. According to the data compiled by FactSet, shared with the Financial Times, the aggregate net debt of U.S. oil and gas production companies more than doubled from $81 billion at the end of 2010 to $169 billion by this June
In the first half of 2015, U.S. shale producers reported a cash shortfall of more than $30 billion. The U.S. independent oil and gas producers’ capital expenditures exceeded their cash from operations by a deficit of over $37 billion for 2014.
In July – September 2015, after a couple months of a rebound, a further slump in crude futures prices fluctuated between $39-47/bbl, thus putting more strain on the oil-and-gas producers, and making them feel an even tighter squeeze.
As The Wall Street Journal reported in August, Exxon Mobil Corp. and Chevron Corp. stated they were cutting stock-buyback programs, while Linn Energy LLC announced it would stop paying dividends to its shareholders. Meanwhile, several small U.S. oil and gas producers have filed for chapter 11 bankruptcy protection this year. Companies with persistently negative free cash flow fall into the trap of borrowing, as they have to incur more debt to repay what they have already borrowed before. This makes such companies vulnerable to default and bankruptcy.
As shared by Edward Morse, Citigroup Global Head of Commodities Research with Oilprice.com, smaller independent U.S. E&P companies are in the worst position now: they are already highly leveraged and are trying to use increased leverage while having to bear high debt pressure.
“They also are in the worst cash flow positions of all of the E&P firms per barrel of liquids production relative to the larger and even the mid-cap firms. However, they also tend to account for a much smaller share of overall production. For example, the large North American E&P companies produce around 5.0-million b/d of oil; mid-sized firms produce just short of 1-m b/d. But the small and smallest U.S. E&Ps combined produce only 500-k b/d, 100k b/d of which comes from the smallest U.S. firms,” stated Morse .
The chart from the U.S. Energy Information Administration below, based on second-quarter results from 44 U.S. oil-and-gas companies, demonstrates the rising share of the companies’ operating cash flow used to service debt.
For the previous four quarters from July 1, 2014 to June 30, 2015, 83 percent of these companies' operating cash had been spent on debt repayments, the highest since at least 2012.
Source: U.S. Energy Information Administration, based on Evaluate Energy Note: Each quarter represents a rolling four-quarter sum.
Debt Worries for Small Companies
According to Forbes, among U.S. E&P companies ranking high on the verge of bankruptcy are Goodrich Petroleum (GDP), Swift Energy (SFY), Energy XXI (EXXI), Halcon Resources (HK) among others. “These companies have all lost more than 90 percent of their market value since 2014, are larded up with too much debt, and would be lucky to survive the bust,” Forbes wrote.
According to FINRA data cited by Forbes, the yield of Goodrich’s issue of 2012 bonds for U.S. $275 million jumped up to 58.66 percent from 8.88 percent during trade sessions this August. The Goodrich’s stock that previously sold at $29 in June 2014 traded at 88 cents. The company has a high leverage ratio (debt to EBITDA): in the first half of 2015, the company’s revenues amounted to U.S. $50 million while its interest expense on servicing of a long-term loan of U.S. $622 million was $27 million.
Energy XXI (EXXI) is snowed under in $4.6 billion in debt. As Forbes reported, the company was negotiating terms for extending maturities on their bonds with creditors; it also managed to find an investor who bought another U.S. $650 million worth of debt from EXXI.
Another company staggering under a heavy debt load is Swift Energy (SFY). According to Forbes, Swift’s equity market capitalization is $27 million against long-term debt of $1.1 billion. As The Wall Street Journal reported in July, the company was trying to find an investor to come up with funds to repay loans by issuing a $640 million bond.
Halcon Resources (HK) is also on the brink of insolvency. 40 percent of Halcon Resource’s revenues this year have been expended on making interest payments on its U.S. $3.7 billion debt. The company did two equity-for-debt swaps earlier this year, and sold more debt for U.S. $700 million, Forbes reported.
As Virendra Chauhan, Oil Analyst at Energy Aspects discussed with Oilprice.com, the smaller independent U.S. producers are the ones taking the most risk, particularly the ones that have been outspending cash flows quarter-on-quarter for the better part of the last three years. “The debt maturities vary, but the key factor is an over 50 percent fall in oil prices. Whilst costs have come down, they are no way near 50 percent; and so the reliance on external funding, be it through, debt, equity, asset sales or by other means, has increased, which is certainly impacting investor sentiment,” he said.
Although quite a few U.S. shale oil producers have reported substantial increases in their productivity per well drilled, the amount of rigs drilling for oil in the U.S. has dropped by 59 percent since its peak in October 2014, according to the EIA data shared by the Financial Times.
In the Eagle Ford shale of South Texas, the volume of oil produced from new wells for every operational rig, has risen by 42 per cent over the past year, from 556 barrels per rig per day to 792, EIA reported.
“Profitability and returns in the U.S. tight oil space is a moving target – many producers claim to be profitable and generate healthy returns, yet their cash flow situation has shown no signs of improving,” pointed out Chauhan. According to the analyst, producers in the Permian are likely to be better positioned than in other areas, as this basin is the least developed of the three major basins, and Pioneer Resources (PXD), which has the largest acreage in the basin is 75 percent hedged for this year with a floor of $67 and a ceiling price of $77 per barrel.
According to the IHS Energy North American E&P Peer Group Analysis Report, the weighted-average hedged prices for 2016 are $69.04 per barrel of oil and $3.83 per thousand cubic feet (MCF) of gas. The midsize E&Ps have hedged 26 percent of estimated 2016 total production. Financially distressed companies with low hedge protection and high risk in 2016 include SandRidge Energy and Ultra Petroleum.
“The small North American E&Ps have hedged 25 percent of estimated 2016 total production and continue to have the weakest balance sheets. With high debt and little hedging, EXCO Resources and Comstock Resources are at risk of serious liquidity issues if low prices prevail,” stated Paul O’Donnell, principal equity analyst at IHS Energy and author of the report.
Many investment banks and financial services companies are already facing losses on substantial investments in E&P companies, as they have committed hundreds of millions of dollars to lend to energy companies on top of the loans provided to them at the time when oil prices were surging.
Among such investment funds taking a hit on their positions in the financially distressed E&P companies listed above (Goodrich Petroleum Co. Energy XXI Ltd, Swift Energy, etc.) are Franklin Resources Inc., Oaktree Capital Group LLC, Lazard Ltd and others.
Financial experts and analysts point out that some E&P companies have managed to refinance their debt, however, it becomes increasingly more difficult for them to do so as their stock and bonds lose value and the high yield return they have to offer to lenders to get financing is higher than in any other business sector.
According to Marketwatch, the energy industry Liquidity Stress subindex has pointed to a high-risk debt weighing on U.S. E&P companies, as it surged up to 16.9 percent in September from 12.7 percent in August, the highest level since it reached 19.2 percent six years ago in July 2009.
As Chauhan of Energy Aspects pointed out, it is fair to say that most oil and gas companies are not generating free cash flow at current oil prices, as these prices are below full-cycle costs for most regions in the world, with the exception of the Middle East, which is the lowest cost producer globally.
Larger Companies Faring Better
“The IOC’s are likely to be better positioned during a downturn because they have higher credit ratings and therefore are more accessible to debt markets. They also have a hedge built into their business because they will benefit from downstream profitability from improved margins,” the analyst added.
As Paul O’Donnell shared in the IHS report, only six percent of the large North American E&P production volume for 2016 production has been hedged, as these companies have stronger balance sheets to withstand the low prices. “No oil-weighted large E&Ps have any significant hedging in place for 2016”, O’Donnell said.
According to Morse, the large North American E&P companies should be able to survive and thrive, given their high production base and their free cash flows as a cover for liquids production.
“They have roughly three times the cash flow coverage as the smaller companies in terms of cash flow per barrel of oil, and they are still increasing production as a group,” commented the Head of Commodity Research.
As the study reveals, some of the large E&Ps’ capital expenditures in 2014 were:
O’Donnell of IHS expects capital spending for the North American E&P group to drop 25 percent in the second-half 2015, as compared with the first-half of 2015, from approximately $60 billion to $45 billion.
As cited by Natural Gas Intelligence in September, “according to EIA, U.S. oil and gas E&Ps had reduced their capex budgets by $38 billion in 2Q2015 (to about $95 billion) compared to the preceding second quarter (about $130 billion), "the difference between cash from operations and capex was almost zero in 2Q2015."
Kinder Morgan is the poster boy for the modus operandi of our entire present regime of Bubble Finance.
The graph below belongs in the “what were they thinking category”.
After Tuesday’s dividend massacre, it’s plain as day that Kinder Morgan (KMI) wasn’t the greatest thing since slice bread after all. That is, a “growth” business paying rich dividends out of rock solid profit margins and flourishing cash flow.
In fact, it was just a momo stock on a borrowing spree.
During the 27 quarters since the beginning of 2009, the consolidated entities which comprise KMI generated$20.8 billion of operating cash flow, but spent $24.3 billion on CapEx and acquisitions.
So the “growth” side of the house ended-up in the red by $3.5billion. Presumably that’s because it was “investing” for long haul value gains.
But wait. It also had to finance those juicy dividends, and there was a reassuring answer for that, too. The payout was held to be ultra safe owing to KMI’s business model as strictly a toll gate operator in the oil and gas midstream, harvesting risk-free fees from gathering systems, transportation pipelines and gas processing plants.
Accordingly, even when its stock price was riding high north of $40 per share, the yield was 5%. So over the last 27 quarters KMI paid out $17.3 billionin dividends from cash it didn’t have.
It borrowed the difference, of course, swelling its net debt load from $14 billion at the end of 2009 to $44 billion at present. And that’s exactly the modus operandi of our entire present regime of Bubble Finance.
Yes, you can chalk this off to another “lesson learned” in the Wall Street casino. After all, some definable group of investors and speculators thought they owned $98 billion of market cap a few months ago, and now their accounts are suddenly $60 billion lighter—–including about $7 billion of bottled air that evaporated from the net worth of its founder and indefatigable promoter, Richard Kinder.
But in the alternative, perhaps its time to recognize that healthy, properly functioning free markets do not make egregious $60 billion “mistakes” such as this one over and over. What surely led to the insane peak valuation of KMI is the relentless scramble for yield that has been triggered by 84 months of ZIRP and endless coddling of the stock market by the Fed and other central banks.
The fact is, during the last 31 quarter (i.e. since Q1 2008) KMI has posted the grand total of $900 million in cumulative net income. This means that at its peak April valuation it was trading a 100X the totality of what it had earned during nearly an entire decade; and that during that period it paid out 17 times more in dividends than it earned.
That’s right. The Wall Street gamblers and punters had followed the pied piper of Houston right out of Enron, and into an even greater bubble predicated on the same old scam.
Indeed, KMI is a pipeline company just like Enron. It’s original building block, Enron Liquids Pipeline, was purchased by Richard Kinder and his partner for $40 million back in the late 1990s.
Yet it had no more chance of being worth $100 billion than Enron had of being worth $60 billion before its implosion. It didn’t even have the razz mataz of a fiber optics trading business or a franchise to bring power and light to impoverished villages of India.
The apologists are want to argue, of course, that net income doesn’t mean anything when it comes to valuation. Perhaps we should therefore dispense with the several billions spent annually by the SEC, DOJ and sundry state attorneys general hauling business executives to court and jail for violating GAAP.
On the other hand, there is a reason why GAAP accounting statements require that asset write-offs, goodwill impairments, restructuring charges and stock option costs be charged to net income. At one point or another every one of these charges involved the waste of cash or other corporate assets.
They are not merely “non-recurring” expenses. They always and everywhere generate a recurring loss of value because these charges reflect a business mistake or the impact of Mr. Market’s penchant for “creative destruction”.
Even then, clamber on board with the LBO boys and consider the LTM results for KMI on a so-called cash flow basis. During the year ended September, it posted $5.89 billion of EBITDA and spent $3.9 billion on CapEx and $1 billion on acquisitions. So its free cash flow was a round $1 billion.
Let’s see. At its April stock market peak, Kinder Morgan’s total unlevered enterprise value (TEV) was $140 billion. So the casino was valuing the company at 24X EBITDA, 70X EBITDA less CapEx and 140X free cash flow!
If you have another pipeline company in Houston, I’ve got some swampland in Florida that I will swap for it.
If not, at least believe this. Two decades of Wall Street coddling by the Fed and 84 months of free carry trade money means that the casino is riddled with momo plays and debt-fueled scams like Kinder Morgan.
Now would be an excellent time to get out of harm’s way - as any sensible KMI shareholder would have done long before Bloody Tuesday.
Now that everyone is finally looking at junk bonds with hopes to buy, sell or short as one's inclination may be, everyone is realizing something we have been warning about since 2012: when times of stress emerge, either the Bid/Ask spread is gargantuan (good luck with those "subject" quotes from dealers who have no inventory), or there is simply no market as the first hint of a buyer or seller make bond traders the carbon-based equivalent of an HFT algo, and pull their quotes. In short: there is no liquidity.
DISTRESSED BONDS - OVer 1000bps
Luckily, there are some very distressed bonds (spread over 1,000 bps) which still trade in volume. The table below, courtesy of Bloomberg, lists the bonds with the largest one-day volume among those that traded yesterday on TRACE at a spread of 1,000 basis points or more than their government benchmark.
For those who want to join the junk bond fray, on either side of the trade, but don't want to be locked out in an illiquid market, these may be your best bets.
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
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