Wednesday, December 24, 2014

Energy "crisis" is a drop in the bucket

This year's plunge in oil and natural gas prices—oil down almost 50% and natural gas down 35%—sparked fears that defaults on energy-related debt could trigger a broad-based economic slowdown and/or financial crisis. Those fears have largely subsided, however, likely because the market has had a chance to look at the numbers, and they are not very scary. The losses on energy-related high-yield debt in recent months represent only 2.2% of the value of the U.S. high-yield debt market, and a mere 0.1% of the value of the U.S. bond market.

Some relevant facts, all drawn from the BoA Merrill Lynch bond database as of 12/23/14:

Market value of all U.S. high-yield debt: $1.35 trillion
Market value of all high-yield energy debt at its August '14 peak: $0.21 trillion (15% of all HY debt)
Market value of all high-yield energy debt (current): $0.18 trillion
HY energy debt losses from peak: $0.03 trillion (14% of HY energy debt, 2% of all HY debt)
Market value of all high grade corporate debt: $5.1 trillion
Market value of outstanding Treasuries: $12.4 trillion
Market value of outstanding mortgages: $9.4 trillion
Market value of all U.S. Treasury, corporate and mortgage debt: $28.3 trillion
Market value of all U.S. equities: $23.4 trillion

The likely defaults on U.S. high-yield energy debt ($30 billion) are essentially a drop (0.1%) in a very large bond market bucket ($28.3 trillion).

$30 billion is a very small number compared to the total value ($51.7 trillion) of U.S. bonds and equities. Losses of this magnitude happen frequently and often many times each day.

Things were much worse in 2008, when HY debt suffered a total return loss of almost one third. The loss suffered by HY energy debt this year from the peak is 13%, whereas total HY debt loss has been only 3.3%.


Marc Semaan said...

Hi Scott,

I was wondering how much should we worry on the labor market dynamics following this sharp decline in oil prices ? I understand the positive effects on consumers however when i look at job creation since 2009, Texas and Minneapolis are the two strongest regions implying the concentration of job creation in energy and energy related fields.

Any thoughts?

Thank you

Scott Grannis said...

There may well be a period of adjustment. The energy sector can't grow to the moon, in any event. As energy cools, other sectors, especially the energy intensive sectors, should sooner or later pick up the slack. But guessing how that might play out is above my pay grade.

William said...

Scott wrote: "Market value of all high-yield energy debt at its August '14 peak: $0.21 trillion (15% of all HY debt)"

That statements is reminiscent of the 2007 comments that "Subprime Mortgages were only 4% of the Mortgage Market; and therefore could not possibly be a problem for the US economy."

I'm not smart enough to know what derivatives might be linked to these Hi-Yield energy bonds or who might own them; but it is a similiar statement.

Benjamin Cole said...

Excellent blogging. No doubt some oil equity and debt will get hurt going forward.

The only threat I see is a LTCM situation, where someone has managed to leverage by hundreds of dollars to each dollar of equity, and now will take down others.

In general, lower energy prices are a boon. The Fed has a lot of running room--indeed I wonder if the Fed can hit its inflation targets for the next couple years.

steve said...

well done scott. the HY market is very emotionally driven due to iliquidity. one thing you didn't mention is that the $1.4T in HY debt is spread amongst literally thousands on issues many of which don't trade for days or even weeks. bill gross in one of his more (and significantly less frequent) perspicacious moments recently commented that the selling HY was like lots of people trying to fit through a very small door. absolutely cannot compare the energy related HY debt market to subprime in '07. $30B Vs what ended up being many hundreds of billions if not over trillion bears no relation.

Marc Semaan said...

Talking about inflation in the US, I don't see why the Fed will be much worried. CPI services is running at 2.5% which is above target suggesting that the domestic demand is strong and consumer behaviour is not changing or affected by inflation expectations. Good's disinflation is a good thing for the economy and consumers in particular. Bottom line, this is a "good" lowflation environment for the US.

William said...
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William said...
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Benjamin Cole said...

Another interesting stat: Unit labor costs have fallen in the last two quarterly readings.

In the last seven years, unit labor costs, as reported by BLS, up up about 4%.

This is a repeat of pattern seen in the 1990s: Output goes up, and unit labor costs go down or moderate. If you have ever run a factory or small business, this makes sense to you (I have). Your business can double, and still need only one accountant on staff. Economies of scale, written small, but big to a small business, present themselves daily. You can order minimum amounts of goods that meet discount requirements.

Economists always drag out the Phillips Curve, which since 1995 should be called the "Phillips Phlat-line."

Whatever, the BLS says unit labor costs have fallen for the last six months, and we see commodity prices are down 20% YOY.

I guess we can still see some niggling amounts of inflation from real estate prices, taxes. But real estate seems to topping out too (I contend even here, there is a smudge between appreciation and inflation, but let that go). .

Boy, the Fed is simply fighting yesteryear's war. Would you expect a federal agency to do any different?

Nick Thorne said...

Could you please do a post on what could happen to the US government when the FED raises rates. I often hear the argument that when the FED raises rates the government will not be able to afford the interest payments on their debt. Would love to get some facts behind this to see if it's actually true. I also realise there is the whole issue of the unfunded liabilities.
I realise the government is not in the best financial position but many clients use the above argument not to invest in the US market for the long term. I have a hard time betting against American capitalism, entrepreneurship and the dynamism of the economy as you mention.
Would love to hear your take on it as your writings are always backed up by facts and well thought out.
Nick. - long time reader.

Scott Grannis said...

Nick: I'd love to give you an answer, but it would be almost worthless if I did. That's because your request amounts to forecasting the result of multiple independent variables (e.g., strength of the economy, when the Fed starts raising rates, how fast they raise rates, the behavior of inflation, the evolving shape of the yield curve, the maturity structure of Treasury debt). The probability of correctly forecasting all those variables is extremely low.

There is at least one good reason to not despair, however. Today the current federal budget deficit is less than 3% of GDP, and it seems likely to shrink further. This is good, since it means that the burden of debt (debt divided by nominal GDP) is unlikely to increase much for the next several years.

Meanwhile, Treasury has been extending the maturity of debt at the same time the Fed has been buying longer-dated bonds in exchange for short-term bank reserves. That means that the Fed will bear the brunt of rising interest rates, not the Treasury, since Treasury has locked in very low long-term borrowing costs. The Fed currently earns a spread over its borrowing costs of about 2% (interest paid on reserves is 0.25%, while interest received on notes, bonds, and MBS is 2% or so). That spread will cushion the Fed's losses for awhile. But at some point the Fed is likely to experience losses as short-term rates rise and the value of its note and bond holdings fall.

The Fed has most likely done zillions of simulations about how this might all play out and they are apparently not too concerned. The Fed also has the advantage of not having to mark its assets to market in a rising rate environment. Plus, the Fed can always "print" the money it needs to pay on reserves, so they shouldn't face a default situation even if their assets decline in value and their cash flow dries up.

It's always possible that things could spin out of control, but the probability of that happening goes down in line with the deficit as a % of GDP.

Benjamin Cole said...

Nick--Keep in mind that rates coul go lower, and that the Bank of Japan has not raised rates in 20-odd years.

Unit labor costs are deflating as we speak. Commodities nosediving.

The Fed has abandoned QE, so any meaningful central bank stimulus is out.

The US is not Japan. So, a repeat exactly of the Japan experience may not be in the cards. But something similar....

William said...

Post Op Ed: "The Laffer Curve turns 40: the legacy of a controversial idea By Stephen Moore

"....This was the first real post-World War II intellectual challenge to the reigning orthodoxy of Keynesian economics, which preached that when the economy is growing too slowly, the government should stimulate demand for products with surges in spending. The Laffer model countered that the primary problem is rarely demand — after all, poor nations have plenty of demand — but rather the impediments, in the form of heavy taxes and regulatory burdens, to producing goods and services.

"....But I’d argue — and not just because Laffer has been a longtime friend and mentor — that his theory has actually held up pretty well these past 40 years. Perhaps its critics should be called Laffer Curve deniers.

Benjamin Cole said...

December 26, 2014
JANUARY ISSUE: Finance–Sea of Liquidity
By Keat Foong, Finance Editor

Fred Schmidt, president & COO of Coldwell Banker Commercial, believes debt and equity capital will be more available in 2015. And that’s good news—at least for now—for the recovering commercial real estate market.

The Mortgage Bankers Association has forecast originations by mortgage bankers will rise by 8 percent by the end of 2015, after an estimated 6 percent bump-up last year. That is still a far cry from the whopping double-digit volume pumps during 2011-13, immediately following the Great Recession. But by the end of this year, total commercial/multifamily originations by mortgage bankers will be substantial—at $407 billion, according to the MBA—almost back to the 2007 peak level of $508 billion. Notably, at an expected $173 billion, multi-family financing in particular should exceed its 2007 peak volume of $148 billion.

That makes for plenty of liquidity to drive the commercial real estate market. If anything, capital appears to be constricted currently by the dearth of appropriate commercial real estate opportunities, rather than by the amount of capital available, at least in the primary and, increasingly, secondary markets. “Everyone complains that there is a lot more money than good deals. … Capital is more aggressive because there are fewer properties; there is a lack of quality out there,” said Danny York, president of Franklin Street Capital Advisors


The above mirrors what I have been experiencing.

Tons of capital everywhere, on the sidelines, in deals, waiting for deals....

Capital is no longer scarce. The world is flooded with capital.

The new normal for interest rates?

Interesting question. Supply and demand in capital markets means interest rates droop to 1% on 10-year Treasuries?

Investors do not like these questions. But cap rates getting shoved down.

It ain't no fun, but "he has the gold rules" might be altered to "he who has the gold, has what everybody has."

interesting times.

Nick Thorne said...

Thanks very much for your reply Scott. And thanks for your fantastic blogging this year. Nick.

William said...

I hate to be a party pooper but it is not a good sign for equity markets when bond yield are falling during a market ralley.

U.S. 10yr 2.190 -0.02 0.9%

German 10yr 0.539 -0.009 1.64%

Italy 10yr 1.862 -0.087 4.45%

Spain 10yr 1.609 -0.065 3.88%

U.K. 10yr 1.794 -0.026 1.43%

When the economy of a country is improving and growing more rapidly, the equity market rises of course; but bond yields also rise as future interest rate increases and future inflation are anticipated.

Is this unusual situation simply explained by the dramatic 50% fall in the price of crude oil??

Scott Grannis said...

William: you are missing an important piece of the picture. Nominal yields have indeed fallen this year, but short-term real yields (particularly 5-yr TIPS) have risen considerably. What links the two (falling nominal yields and rising real yields) is declining energy prices, which have lowered inflation expectations, and increased confidence in the economic outlook, which has pushed up real yields.

Real yields on German 5-yr inflation indexed bonds are up 60 bps in the past six months and up 140 bps since March 2013.

William said...

Thank you,Scott. I'll try to get my head around your explanation ;~)