The Purgative Of $80 Oil: Junk Bond Mullets Are Getting Fracked

It’s now called a “collapse”: The US benchmark light sweet crude plunged 4.6% to settle at $81.84 a barrel on Tuesday, the lowest since June 2012. In London, Brent made a similar journey to $85.04, its lowest level since November 2010. Explanations abound why this is suddenly happening, after years of deceptive calm.

Is it some harebrained plot to punish Russia by destroying its economy? Signs of success are everywhere. The ruble is in free fall despite the central bank’s efforts to prop it up. Yield on Russia’s 10-year note is nearly 10%. The government’s budget, heavily dependent on oil revenues, is in trouble. And every unit of foreign currency that isn’t nailed down is fleeing the country.

Or is it a plot by Saudi Arabia to squash the US shale oil boom? In November last year, the Saudi Gazette published an editorial on the “successful, wise, and balanced OPEC strategy” that led to “unprecedented” stability of oil prices for the past few years of around $106 a barrel. But couched in words such as “skeptics are demanding,” it uttered the threat to raise OPEC production until the price would drop “below $70 a barrel” to “remove the shale oil from the world oil production map….”

Or is it the combination of surging production in the US and sagging demand around the world, particularly in China and Europe?

Demand for oil would inch up this year at the slowest rate since the terrible year of 2009, the IEA predicted. OPEC might not be willing or able to lower production, it said. Why? Because of the US shale boom. And so, “Further oil price drops would likely be needed for supply to take a hit – or for demand growth to get a lift.”

Whatever the reasons for the market chaos, we already know what it has accomplished in the US: Investors who were long when they sleepwalked into this new era that started in late June have had their heads handed to them. WTI gave up 21% in less than four months. Over the same period, the SPDR Oil & Gas Equipment & Services Fund (XES), a basket of the largest oil- and gas-related stocks, plummeted 33%. Shares of smaller oil and gas companies have gotten demolished.

Reason for this mayhem: the toxic mix of high debt and plunging oil price.

The oil and gas sector is capital intensive. Drillers have borrowed phenomenal amounts of money, which was nearly free and grew on trees, to acquire leases and drill wells and install processing equipment and infrastructure. Even as debt was piling up, the terrific decline rates of fracked wells forced drillers to drill new wells just keep up with dropping production from old wells, and drill even more wells to show some kind of growth. One heck of a treadmill. Funded in part by junk debt.

Junk bond issuance has been soaring as the Fed repressed interest rates and caused yield hungry investors to close their eyes and take on risks, any risks, just to get a teeny-weeny bit of extra yield. Demand for junk debt soared and pushed down yields further. And even within this rip-roaring market for junk bonds, according to Bloomberg, the proportion issued by oil and gas companies jumped from 9.7% at the end of 2007 to 15% now, an all-time record.

While the overall high-yield market is down 2.3% since the end of August, oil and gas junk debt has dropped 4.6%. But as Bloomberg reports, it hides the bloodletting beneath the surface.

Samson Investment, an oil and gas explorer headquartered in Tulsa, OK, owned by private equity firm KKR, extracted $2.25 billion of new money from gullible investors in July. In early August, these junk bonds still traded at 103.5 cents on the dollar. Then reality sank in, and that formerly low-risk paper plunged to 77.5 cents on the dollar.

Not just in fracking la-la land. Paragon Offshore, an offshore driller, completed its spinoff from Noble in early August. Its stock started trading at $17.50 a share and immediately plunged and is now down a cool 68% in the first 10 weeks as an independently traded company. In July, it also sold $580 million in 10-year junk bonds to your bond fund at 100 cents on the dollar. Now they trade for 77.3 cents on the dollar.

Hercules Offshore, a Houston-based drilling company with the appropriate ticker HERO, saw its shares plunge 81% since July last year to $1.47. In March, it had the temerity to sell – or rather investors had the Fed-induced idiocy to buy – for 100 cents on the dollar $300 million in junk bonds that now trade at 66 cents.

This is what happens at the tail end of a credit bubble. Investors still lust for high-risk debt because it offers a little more yield in the era of ZIRP, but that yield did not compensate investors for the risks they were taking on. Companies and Wall Street did what the Fed had wanted them to do: issue junk and push it into retirement portfolios where it can quietly decompose. And bamboozled investors – thinking that the Fed was the best thing since sliced bread – took this debt with a desperate smile.

Now that the bottom is falling out, it is getting more expensive for these companies to borrow. Newly awakened investors are demanding to be compensated at least a little for the risk, and that risk has now been exacerbated by the collapse of the price of oil. That’s the toxic mix. If the money stops growing on trees, the jig is up for many of these companies, and the American fracking boom may well do what other oil booms have done before, and what OPEC would like it to do: grind to a halt. And investors would lose their oil-stained shirts.

The broader market has, let’s say, some issues: “Too many poorly understood structural changes have created unstable markets. Now comes the dismount.” Read… Why the Market Swoon May Become “Disorderly on a scale not seen since the crash of 1987