The oil industry looks downright abysmal right now any way you slice it.
Earnings are in the tank, the number of bankruptcies is shooting through the roof, and layoffs are widespread.
The only solace that one could take from all of this is that the damage appears to be contained for the most part to the oil industry. In fact, many market watchers are presenting statistics “ex-energy” to get a better picture of what is really happening in the economy.
The biggest instance of this thinking is in the credit space, as the high yield bond default rate for energy companies has shot up to nearly 20%. Otherwise, high yield default rates sit around 3.5%, much closer to the historical norm.
This line of thinking, according to a note circulated by Deutsche Bank’s Oleg Melentyev and Daniel Sorid, is a mistake.
The credit strategists looked at the past two turns in the credit cycle in 2001 and 2008, and stripped out the worst performing sectors to see the impact in the overall default rate. The blue lines show overall defaults while the other colours illustrate the still-high default levels in sectors other than the worst performing sector in each downturn:
“Default cycles of the past have never been about a single sector, or small group of sectors,” said the analysts. “Yes, cycles were always driven by concentrated distress but they always found their way to affect other areas of the market.”
There are reasons to assume that it is, as they say, different this time around. For one thing, oil prices are rebounding, so that could alleviate the energy sector’s issues somewhat. Another difference is that both of the last two credit cycles coincided with an economic recession, while projections are for the US to continue its slow and steady growth.
And finally, a downturn in the oil sector usually supports consumers’ incomes via savings from low gas prices and could actually drive economic growth eventually, as opposed to dragging the whole economy down as tech and finance did in the past two cycles.
The problem here, according to Melentyev and Sorid, is that other sectors have also seen their default rates rise along with the energy industry’s, meaning the problem is already spreading. The retail industry, which should theoretically be a beneficiary of oil’s weakness, has the second-highest rate of high yield defaults.
“The biggest surprise here is the contribution of the consumer products sector to the current default environment, where multiple issuers have hit the wall recently, including Quicksilver, American Apparel, and Aeropostale among others,” wrote Melentyev and Sorid. The analysts also cited capital goods manufacturers as another example of a non-commodity sector with increasing default rates.
The upshot of all of this is that special circumstances can cause a downturn in a certain sector, like the housing bubble taking down the financial sector in 2008. That doesn’t mean the ramifications are going to be limited to that part of the economy. Financing conditions can tighten and economic ramifications can infect other sectors.
Ignoring the upward creep in high yield defaults because “it’s just an energy problem” is therefore short-sighted.
Or as the analysts put it:
A frequent argument is being made here how all problems are going to stay limited to the commodity sector. Evidence like this, coupled with emerging credit pressures in retail and capital goods sectors, suggest a contained cycle to be a weak starting assumption.
It’s all connected.
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