Fed Bubble Bursts in $550 Billion of Energy Debt

Bubbles do not end well. Wall Street sucked investors into the high yield junk bond market with the expectation oil prices would continue to rise. With oil prices plunging these investors now face huge losses. With oil at $60 a barrel many oil companies, especially oil fracking companies, will not be able to service the debt.

Kind of like the false premise home prices would never fall. Investors seem to never learn. Wall Street make money fast brokers tell a good story. Too bad most don’t end well.

Fed Bubble Bursts in $550 Billion of Energy Debt: Credit Markets

By Christine Idzelis and Craig Torres Dec 11, 2014

The danger of stimulus-induced bubbles is starting to play out in the market for energy-company debt.

Oil Rigs at night.
Oil Rigs at night.

Since early 2010, energy producers have raised $550 billion of new bonds and loans as the Federal Reserve held borrowing costs near zero, according to Deutsche Bank AG. With oil prices plunging, investors are questioning the ability of some issuers to meet their debt obligations. Research firm CreditSights Inc. predicts the default rate for energy junk bonds will double to eight percent next year.

“Anything that becomes a mania — it ends badly,” said Tim Gramatovich, who helps manage more than $800 million as chief investment officer of Santa Barbara, California-based Peritus Asset Management. “And this is a mania.”

The Fed’s decision to keep benchmark interest rates at record lows for six years has encouraged investors to funnel cash into speculative-grade securities to generate returns, raising concern that risks were being overlooked. A report from Moody’s Investors Service this week found that investor protections in corporate debt are at an all-time low, while average yields on junk bonds were recently lower than what investment-grade companies were paying before the credit crisis.

Borrowing costs for energy companies have skyrocketed in the past six months as West Texas Intermediate crude, the U.S. benchmark, has dropped 44 percent to $60.46 a barrel since reaching this year’s peak of $107.26 in June.

Yields Surge

Yields on junk-rated energy bonds climbed to a more-than-five-year high of 9.5 percent this week from 5.7 percent in June, according to Bank of America Merrill Lynch index data. At least three energy-related borrowers, including C&J Energy Services Inc. (CJES), postponed financings this month as sentiment soured.

“It’s been super cheap” for energy companies to obtain financing over the past five years, said Brian Gibbons, a senior analyst for oil and gas at CreditSights in New York. Now, companies with ratings of B or below are “virtually shut out of the market” and will have to “rely on a combination of asset sales” and their credit lines, he said.

Companies rated Ba1 and lower by Moody’s and BB+ and below by Standard & Poor’s are considered speculative grade.

Stimulus Effect

The Fed’s three rounds of bond buying were a gift to small companies in the capital-intensive energy that needed cheap borrowing costs to thrive, according to Chris Lafakis, a senior economist at Moody’s Analytics in West Chester, Pennsylvania.

Quantitative easing “has been one of the keys to the fast, breakneck pace of the growth in U.S. oil production which requires abundant capital,” Lafakis said.

One of those to take advantage was Energy XXI Ltd. (EXXI), an oil and gas explorer, which has raised more than $2 billion in the bond market in the past four years.

The Houston-based company’s $750 million of 9.25 percent notes, issued in December 2010, have tumbled to 64 cents on the dollar from 106.3 cents in September, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. They yield 27.7 percent.

Energy XXI got its lenders in August to waive a potential violation of its credit agreement because its debt had risen relative to its earnings, according to a regulatory filing. In September, lenders agreed to increase the amount of leverage allowed.

Bubble Risk

Greg Smith, a vice president in Energy XXI’s investor relations department, didn’t return a call seeking comment.

The debt rout is one of the latest examples of a boom and bust in U.S. markets as unprecedented Fed stimulus fuels a hunt for yield. The fallout has been limited so far, yet the longer the Fed holds its benchmark lending rate near zero, the greater the risk of more consequential bubbles, according to former Fed governor Jeremy Stein.

“To the extent that highly accommodative monetary policy courts risks to the economy further down the road, there is more of a live trade-off than there was at 8 percent unemployment” said Stein, now a Harvard University professor.

Joblessness of 5.8 percent in November was about half a percentage point away from the Fed’s estimate of full employment, or the lowest level of labor market slack the economy can sustain before companies bid up wages.

Job Creation

Employment in support services for oil and gas operations has surged 70 percent since the U.S. expansion began in June 2009, while oil and gas extraction payrolls have climbed 34 percent.

“There are distortions in multiple markets,” said Lawrence Goodman, president of the Center for Financial Stability, a monetary research group in New York. “It is like a Whac-A-Mole game: You don’t know where it is going to pop up next.”

Fed Chair Janet Yellen said in a July 2 speech in Washington that she saw “pockets of increased risk-taking,” including in the corporate debt markets.

Midstates Petroleum Co. (MPO) is spending about $1.15 drilling for every dollar earned selling oil and gas. Outspending cash flow is the norm for many companies in the U.S. shale boom.

The Houston-based company’s $700 million of 9.25 percent notes due in June 2021 have plummeted to 53.5 cents from 108 cents at the beginning of September, according to Trace. The debt is rated Caa1 by Moody’s and B- by S&P.

Representatives of Midstates didn’t respond to phone calls and e-mails seeking comment.

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