This “Bubble” Is Set to Kick Off New Energy Profits
Commodities / Oil Companies May 15, 2015 - 05:15 PM GMTBy: ...
MoneyMorning.com 
Dr. Kent Moors writes: The tide is beginning to turn for crude oil prices.
Following some nice recent gains and despite leveling out yesterday, the market currently remains at just above $60 a barrel for West Texas Intermediate (WTI) crude oil futures in New York.
The recent rise in prices would seem to be just what the smaller operators in the U.S. need to avoid a sector meltdown.
A few months back, when prices were pushing lows of $40 a barrel, there was widespread talk of a wave of bankruptcies coming in the oil patch. The picture is now better, given a recovery in crude prices.
But there is another shoe about to fall in the ongoing fight by smaller companies to survive.
Here’s my take on the disaster that’s brewing… and the opportunities it may bring…
Here Comes the Next Debt Bubble
A major energy debt bubble is rapidly forming. Moving forward, it will put significant pressure on the sector.
Make no mistake: There will be fewer oil producers in the U.S. at the end of the year than there were at the beginning… even if the overall pricing trajectory remains pointed up.
Now, that is not necessarily a bad thing from our investment standpoint. Well-positioned and well-managed producers will acquire choice drilling assets and leases at discount. That will raise both their bottom lines and our profitability.
But the terrain is changing.
This week, a bout with rising bond yields has once again put pressure on the Achilles’ heel of most small operators. Most American E&P (exportation and production) companies have been cash poor over the past decade, regardless of the price of oil.
Essentially, this means it has cost them more to fund ongoing operations than they have realized in revenues. When prices for oil have been $75 or higher, this spread has made little difference. In such an environment, it is usually better to fund the bulk of forward operations by rolling over debt than by tapping cash.
Especially if the company is publicly traded. In a higher (and stable) oil pricing situation, cash proceeds translated into a higher offered dividend constitute a better return for the company’s share value than a rapid retirement of debt.
Why Producers Are Still Making Less
Yet this remains all about the price commanded for the commodity.
Remember, the price flashing in the corner of your TV screen is a futures contract. The company taking the oil out of the ground makes a lower price.
The first pricing stage is at the wellhead. This comprises the transfer of oil coming out of the ground to a distributor. That is what the operator realizes as revenue, but it is hardly the final price. Rather, the price is then adjusted upward as it transits to a refinery (the primary end user of the raw material crude) and then onto retail consumers as finished oil products.
Depending on the grade of oil produced (based on factors such as weight, sulfur content, and impurities), the producing company is making a lot less. At $60 a barrel, the average U.S. producer is making somewhere around $50.
And that means even with overall prices improving they are not rising fast enough to avoid an oncoming squeeze.
Energy debt is found at the upper end of the high-yield debt curve. That is often referred to as “junk bond territory” – issuances below investment grade. Since this debt has a higher risk of default, it provides a lower face value and a higher interest rate.
That is simply a risk premium – the issuing company realizes lower funding and has to pay more to receive it. To stay afloat, leveraged oil companies need to be able to roll existing debt over and access debt markets for additional funding
Unfortunately, as oil prices retreated some 60% between August 2014 and February 2015, the yield curve exploded. As junk bond yield rates increased, energy yields expanded even quicker, as shown in the following chart of high-yield (HY) energy spreads.
The current recovery in oil prices has helped a little, but the pricing floor it is not rising quickly enough for the most vulnerable companies.
Currently, there is almost $1 trillion in such oil company junk bonds outstanding. And the interest commanded on new issuances is accelerating. As of last week, oil company annualized interest rates stood between 12% and 15%. As bond interest rates in general were rising this week, energy bond rates were deteriorating even more.
High-Risk Interest Rates Trump Safety
How bad is this deterioration? Aggregate figures are not always indicative of what is really happening in the debt market, except in this case. Bond interest rate changes are quoted on basis points. Each 1% revision is divided into 100 basis points. That allows us to calculate a convenient yardstick of how one particular component of the market is faring against a broader spectrum of debt.
My estimates as of close of trade on Tuesday are indicating a significant bubble forming in indebted oil companies’ abilities to weather the debt storm. Each 1 basis point rise in investment grade debt yield has translated into a (quite generalized) rise of almost 2 basis points in junk bonds.
But the rise is almost twice that for energy junk bonds.
The conclusion is direct: High-risk interest rates are almost doubling over safer bonds, while the energy portion of the junk market is experiencing a rise approaching four times safer debt.
Of course, much of this is a function of a massive re-pricing in global debt, with at least some of it due to the market deciding (not always for the best of reasons) to do the Fed’s job for them. The continuing acceleration in debt yields, therefore, is not likely to continue at such a pace for much longer.
But it has already done some significant damage to the most exposed oil producers.
How Companies Will Survive… And We’ll Profit
To survive during periods of low prices, companies need to hedge. That means they will take out futures contracts on their own forward production. But actual market prices for the product at contract expiration need to match the hedge (and the combined series of options companies will take on that contract).
And for that to happen, the breakeven for the cost of operations versus the market price of the oil produced must be at a level allowing for the debt load to remain manageable.
That is becoming more difficult. My current projections put the breakeven at about $74 a barrel by July for the bulk of shale and tight oil production in the U.S. This is the primary contributor to the new production surpluses experienced.
My expected market (not wellhead) price by the end of July is only $65-68 a barrel. Most companies will still be able to hedge forward for another eight to 12 months. However, unless we have a rapid rise in oil prices during the second half of this year, the cost of hedging will become prohibitive and the range unpredictable.
By the end of December, I calculate that the breakeven price for shale/tight oil production will be about $76 a barrel, while the WTI market price will be between $73 and $78. That will allow the resumption of more normal hedging and more workable bond yields.
Unfortunately, there will be casualties well before we reach December. Expect a rising bankruptcy rate and a robust mergers and acquisitions (M&A) cycle to kick in by summer.
The M&A will provide us with some nice opportunities to make profits from the energy debt bubble.
Source :http://oilandenergyinvestor.com/2015/05/this-bubble-is-set-to-kick-off-new-energy-profits/
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