In writing this article, I attempted to explain current market movement using theory extrapolated from class. This post hopes to inform fellow students about investor sentiment towards high yield oil and gas bonds using concepts seen in class such the Theory of Asset Demand, and related topics like yield to maturity, bond spreads, risk and credit ratings.
For those unfamiliar with the Theory of Asset Demand, four major factors contribute to demand curve shifts in the supply and demand framework of that security; they are wealth increases/decreases, expected return increases/decreases, liquidity increases/decreases and perceived riskiness increases/decreases. In our case, an increase in the perceived risk of the asset due to deterioration of industry fundamentals has led to a leftward demand curve shift thus decreasing price. Naturally, yield to maturity has risen due to its inverse relationship with price.
With the framework having been set, the rest of the article attempts to explain the recent change in market fundamentals and how this has impacted bond returns for high yield oil companies.
Oil and gas is an inherently capital–intensive industry that requires large amounts of capital expenditure to fuel company growth. In order to fuel and sustain this growth, companies must often leverage themselves to finance production activities and new projects. Bonds markets provide these companies with a very important source of financing as the cost of capital in these markets are usually the cheapest.
With many variations in maturity, cash flow generation capabilities, and capital structure (balance sheets), credit ratings for oil and gas companies differ widely. For example, Exxon Mobil’s exceptional credit rating reflects the strength of its balance sheet and its ability to meet debt-servicing obligations with cash flows. As a result, Exxon’s debt has a relatively lower yield to maturity (their cost of capital) in comparison to riskier high yield junk bonds.
With the framework having been set, the rest of the article attempts to explain how recent changes in market fundamentals heavily impacted bond returns for high yield oil companies.
Since June 2014, the price of WTI crude oil has slid from highs of around $107 dollars per barrel to its most current price of $75.82 per barrel. The primary reason for this downward pressure can be explained by price-cutting measures and increased production from one of OPEC’s largest producers, Saudi Arabia. These trends could persist, as many believe Saudi Arabia is seeking to increase its market share by taking aim at US energy companies with much higher costs of production and breakeven points.
As crude oil prices continue to decline, margins for oil companies continue to constrict. This decrease in profitability for oil companies leads to an increase in the risk of default on interest obligations (especially those with high breakeven points and credit ratings), which increases investors’ risk of holding these market securities. As we have seen, this spurred a massive outflow of investment from fixed income investors in these high yielding bonds. The decrease in demand for these bonds results in lower prices (capital losses) on issued bonds and an increase in the yield to maturity investors expect to receive on newly issued bonds to compensate for the risk of holding these assets. The Bi North America High Yield Oil E&P index (BINAHOCP) provides empirical evidence of the market selloff. The index, which tracks companies with lower grade credit ratings, hit a low of 59.54 on October 15th from a high of 108.09 on July 1st.
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