Oil's getting drilled....

The major market development of the past few days has obviously been the ongoing decline in energy prices, spurred by the recent decision from OPEC to stand pat rather than cutting production. Oil's certainly not looking too slick these days, which naturally calls to mind a whole skein of commodity-related puns.   In the original iteration of your author's stewardship of this space, he wrote an entire post chronicling a list of them (aided admirable by numerous contributions in the comments section.)  Imagine his surprise to find that it was written six years ago to the day.  Plus ca change....

On a more serious note, a number of brain cells have no doubt been taxed attempting to assess the impact of the decline in energy prices.   In areas where taxes make up a large percentage of the retail price of petrol (like most of Europe and, it appears, Macro Man's home state of Connecticut), the impact is of course quite modest as the taxes don't change with the underlying fuel costs.  For the United States as a whole, of course, the price represents a fairly tasty windfall for consumers- some $75 billion over the past six months alone.

Of course, that needs to be balanced by the impact of lower oil on the ongoing development of alternative petroleum sources, which could perhaps shave off roughly half of the boost to consumption from overall growth.

A number have commenters in recent days have noted the potential impact upon the high yield market, given that much of the exploration boom was financed by junk bonds.  To be sure, on an individual security basis it is difficult to state with any certainty how and when the lower price point for crude will either change development plans or disrupt cash flows.  This naturally depends on the extent duration of the current swoon, the breakeven for a given project, the hedging practices of the firm in question, and a myriad of other factors.

We can however get a broad sense of the scale of the issue.  Macro Man got a list of every security in the IBOXX high yield index (hat tip: AC) and broke them down by industry.  If one included just about every business related to hard commodities and energy, we get 26.5% of the index- approximately $137 billion worth of securities.

Winnowing it down to just oil exploration, services, and pipelines, we get 14.16%- still a quite tasty sampling.  One JP Morgan analyst seems to think that 40% of "energy" names could default in a few years should crude remain pinned below $65/bbl.   It's not clear, however, what industries he's including in that total:  coal?  utilities?   It's hard to see why the local power company, for example, should go bust just because crude is back to where it was in 2006.

However, if we take the analyst's figures at face value, what are we left with?  A worst-case scenario in which 40% of energy names, which comprise 18% of the index, default: in other words, a default by 7.2% of the index over a multi-year horizon.   Given that the yield on the ETF version of the index is currently 5.8% and the price has adjusted downwards by 5.85% since oil prices peaked in July, one might reasonably believe that a lot of bad news is already priced in.

If all we had to worry about were fundamentals, that argument might hold water.

Unfortunately, the new regulatory landscape is one that will amplify, rather than mitigate, the shock waves from events like energy sector defaults in the high yield sector.  Now, the people who have designed the current regulatory regime might tell you that it's a good thing that people who own the bonds of defaulting companies should take a haircut.   It's hard to disagree in principle.   They might also tell you that banks should not use taxpayers' money as a put to speculate on things like high yield bonds.  This is fine, although it is not immediately obvious that the solution is to ban 'speculation' or 'prop trading' altogether; if it were, why were these activities not also banned for the one financial asset that the United States Government happens to manufacture?

However, by forcing market-makers to act as brokers for products like high-yield credit (i.e., to act as an agent rather than a principal), the authorities have left a gap as wide as the Grand Canyon:  What if there are no buyers?

As we saw in 2008, price declines do not occur in a vacuum; they inform the intentions of other investors, potentially creating a snowball effect.   In such a circumstance, price really is news, and a crescendo of price declines ostensibly unjustified by underlying economic fundamentals is the result.  

Hopefully such a catastrophe is avoided, there is no mass wave of defaults, and everyone lives happily ever after.   Of course, hope is not a strategy.  It would be a shame, however, if an ostensibly net positive externality like lower oil prices in an oil-importing country were to impair the road to energy independence (and perhaps a few other roads, too) because the real economy was starved of capital as a result of an unnecessary high-yield crisis.