We follow economic drivers that impact your equity returns very closely here at Montaka. One of the key economic drivers that is impacting many global industries and markets is the oil price. We have written about the oil and gas space before, which can be found here, here and here.
As we have noted in the past, the primary driver of the recent collapse in oil prices has been oversupply. As illustrated below, US oil production has approximately doubled over the last decade – while in more recent times, OPEC production reached a three year high in 2015.
The doubling of US production stemmed from the “fracking” boom that started to take off just prior to the GFC. Fracking is basically a newly-mastered technology that allows producers to extract oil and gas from shale. As illustrated in the chart below, without fracking (light blue bars), US oil production would have been in structural decline.
To achieve such incredible rates of production growth, an enormous amount of investment took place in the US. This boosted US economic growth, particularly in oil-rich regions such as Texas and North Dakota. The chart below illustrates aggregate oil and gas capital expenditure in the US measured in US$ billions.
What is often overlooked, however, is the funding source for this investment. The structure of funding matters: equity funding can absorb losses, if necessary, a lot less disruptively than debt funding. And equity funding surely played a large roll. But debt funding became increasingly important from around 2011. The chart below illustrates the rapid acceleration in the level of net debt on the balance sheets of US oil companies (horizontal axis) versus US production levels (vertical axis). It’s a great illustration of the correlation between the two.
The existence of significant debt on the balance sheets of producers can create some interesting unintended consequences. For example, highly-levered producers are incented to produce more oil when prices fall, rather than less. More production is needed to generate the cash flow required to service the debt on the balance sheet. While such a decision is individually rational, it is collectively irrational. As an industry, oil producers would be better served collectively cutting production to keep prices higher. The existence of debt could well ensure that prices remain lower for longer.
Furthermore, debt funding – whether in the form of bonds or bank loans – are considered to be relatively safe assets in the eyes of the holder. It is for this reason, therefore, that the funding of these debt assets are also often levered. A bank, for example, may be holding only 10 percent in equity capital against a loan; while bonds are also often held by levered investors. The implication here is that, should credit losses emerge, these may well be multiplied into much larger percentage losses of underlying equity capital throughout the financial system.
While the credit losses observed to date have been relatively minor, the market-implied probability of default has clearly been rising. As illustrated by the chart below, credit markets have never been more concerned than they are now about potential defaults in the oil and gas space.
Montaka holds a number of short positions that will protect against credit losses in the oil and gas space. In Montaka’s long portfolio, we have ensured that none of our businesses in the Financials industry are holders of bonds related to the oil & gas space.
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.