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India has been rejoicing the fall in oil prices globally. The government is twice as happy as the general public since they have increased taxes on oil products even while periodically asking oil companies to reduce prices.
However, all is not well in oil producing countries. Apart from the Organization of Petroleum Exporting Countries (Opec), which is finding it difficult to balance their budget, the biggest problem of falling oil prices is in the US.
The world’s largest economy today is also the largest producer of oil, more than even Saudi Arabia and Russia, thanks to the shale oil boom there. However, production of shale oil is a costlier affair as compared to traditional methods of crude oil extraction. Shale oil production, depending on the location, costs anywhere around $40 to $70 per barrel as compared to sub $10 per barrel levels by Opec.
With oil prices now around the cost of production, the first signs of the jitters are visible in the bond market, especially the energy junk bond market, also known as the ‘cov-lite’ energy bonds. Safeguards known as covenants are embedded in the bonds sold. Energy bonds sold, especially to energy transportation companies had fewer covenants and thus called ‘cov-lite’ bonds. Junk bonds are debt instruments carrying a rating of BB or lower. According to a Financial Times article (paywall) bonds sold by companies that transport oil and gas have emerged as some of the weakest deals in terms of protection offered to lenders.
These ‘cov-lite’ bonds have surged in recent years as demand for higher-yielding assets on account of easy cash due to quantitative easing picked up. Most of the oil transportation companies benefited from such demand when oil prices were higher.
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Lower oil prices would prevent further expansion and investment in shale oil exploration and might also result in lower production. This in turn would impact revenues of oil transportation companies. According to Moody’s ‘covenant quality index’ which measures the quality score of covenant bonds, the scores are the weakest till date and have been running long for the longest period of time.
Low oil prices naturally are bad for the entire oil sector. Shale oil has been one of the biggest reasons for the US economy getting back on its feet. It has provided employment to millions and revived capital expenditure in the economy. From one of the largest importer of oil, USA today is a net exporter. The energy sector accounts for roughly one-third if S&P 500 capex and nearly 25% of combined capex and R&D spending.
According to JP Morgan, oil companies now account for 18% of high yielding bonds as compared to 9% in 2009, when oil prices had briefly touched $40 a barrel. Analysts at JP Morgan say that if oil prices stay below $65 and stays there for the next three years, then upwards of 40% of all of these bonds could default.
