Last week, the high yield market seized up, in part due to jitters surrounding a high profile freeze of funds at the Third Avenue Focus Credit fund. The big problem for Third Avenue was energy high yield credit and the contagion from that sector into other credits. This latest event bears some similarities to the fund freeze at three funds at BNP Paribas in August 2007. And I think it makes sense to think of energy high yield as the equivalent in this credit cycle of residential MBS in the last cycle. So I want to put what’s happening in a broader context and make some conclusions about what it says about the credit cycle.
A month ago, I wrote a piece on zero rates, resource misallocation, and shale oil that warned of the potential negative impact that low oil prices could have on the funding for shale drillers and the potential contagion this drying up in funding could have in risk markets like high yield bonds. My conclusion was that the energy high yield market was one to watch, but that an ugly scenario was not yet upon us. In the month since I wrote that piece, however, the scenario has become somewhat more negative and I want to explain what I think is happening in oil markets and how it is related to both the US economy and US high yield.
The Russian economy is barely growing. The Russian central bank has no intention of supporting the ruble. We are also seeing some spillover from the Ukrainian mess.
Central banks of several nations who are experiencing sharp currency declines are taking action to stabilize the situation. But not the Russians. The nation’s central bank likes the weak ruble because the currency decline boosts the domestic proceeds from Russia’s energy exports. This is particularly important to them as energy prices remain subdued.
We’ve had a number of questions on energy sources in the United States – particularly with respect to the generation of electricity. Here are a few interesting facts about recent trends that hopefully help clarify some of the confusion surrounding this topic.
Scarcity is a powerful force and it leaves those in control of limited resources wielding great power. We think a scarcity of uranium will increase Russia’s power; control over some of the last big, easy oil deposits has earned Saudi Arabia great global influence. Petronas’ deal with Progress is a sign that shale gas could generate similar prowess for North America, and is a strong reminder that the global race for resources will provide some with money and power while leaving others in the dust.
There is some evidence that recently discovered shale oil fields cannot be successfully exploited at prices under $100 a barrel.
As predicted earlier this year, Japan continues to struggle with its energy needs. The chart below shows the recent trend in Japan’s imports of residual fuel oil. These fuel imports are quickly translating into a rising trade deficit.
Take a look at the long-term charts of crude oil and natural gas. The historical oil-to-gas price ratio had ranged from 6:1 to 10:1 before the economic crisis. Since one barrel of oil contains the energy equivalent of the 5.825 million BTU of natural gas, an implied BTU arbitrage kept this relationship in check.
Whatever happened to fuel switching between natural gas and diesel? The switch from diesel to natural gas is one of the biggest types of fuel switching in transport. You see this with all the buses now running natural gas instead of diesel. Other companies with fleets of cars and trucks are making the switch too. So, peak oil or not, you know something is not right when diesel fuel is hitting record highs across Europe and Gasoline is edging toward $4.00 a gallon in the US while natural gas prices are at 10-year lows.
A chart of gasoline consumption and oil prices for the years 2000-2011.
Quick, what country is the economic engine that will power world growth? If you answered “China,” you’re far from alone. But there’s another country that deserves as much attention and better yet, is much friendlier to investment: India, home to 1.2 billion people. To electrify all those houses, power the industries that keep all those people employed, and fuel the vehicles that more and more Indians own, India’s energy needs are shooting skyward.