We need to talk about oil

Markets dived again this week and cheap oil is looking like more of a hindrance than a help. Its more obvious negative effects aren’t helping banks; but again the outlook warrants a reality check in bank stocks , not the current mass exit. There are plenty buffers left before banks hit a systemic crisis – unless panic crashes through them. When markets are this jumpy, companies and investors can freeze, thinking that they’re missing something major. So it’s worth taking a moment to ask if some signals aren’t what they seem. Is red is the new amber? And it might seem a curious time to talk about divestment, but it’s one way that we see companies getting ahead of the curve in difficult times.

TurmOIL

A few weeks back we commented that: “There is only so much more demand cheaper oil can generate, whilst the impact on the sector, markets, capex etc is large and tangible now.” Let’s just come out and ask the question it: Is there a point where the negatives of cheap oil outweigh the benefits?

 More simply: Can oil be too cheap?

It’s a question that more people are asking as hopes of tighter supply fade and negative feedback loops develop across capital markets. Central banks are pumping in vast amounts of liquidity, but what of petrodollars? Before the price crash, oil exporters’ strong current accounts allowed them to invest trillions via sovereign wealth funds (SWF). Amongst other effects, these funds helped support growth in emerging markets, which supported demand for oil, thus generating more returns for funds to invest.  The Royal Bank of Scotland’s Head of Credit Macro Research, Alberto Gallo, estimated that the gross flow of these petrodollars into the global economy fell to $200bn last year from $800bn in 2012. Given the growing chance of current account deficits in these economies, I imagine this number has fallen south since, increasing the risks to emerging markets. 

Producer countries are also seeing a destabilising effect. Venezuela either needs to cut imports or default on its debts. Nigeria and Azerbaijan are in talks about emergency loans. Russia has assets on the block. This destabilisation is just one reason why equity markets and oil prices are moving in an unusual lock-step. Theoretically, cheaper oil should encourage more consumption (and higher net corporate earnings) because consumers are more likely to spend excess cash than oil producers. That’s not happening yet. As The Wall Street Journal recently put it:

“…the drags on the energy-intensive sectors of the economy have been immediate and worse than anticipated, as some initially warned might happen when prices first began to fall. The lift for the broader economy has been slower to materialize and weaker than expected.”

We can see the sector drag clearly in EY’s fifth annual review of the UK oilfield services (OFS) industry. The oil price decline has resulted in many projects being delayed or cancelled; growing margin pressure on capital projects and operation and maintenance contracts; and a lack of visibility over future orders, creating unprecedented stress all long the supply chain beyond the oil & gas sector. Exposed companies will need to cut their cloth accordingly.  We expect to see considerably more consolidation in OFS as companies in the sector either stick or twist. 

Debt amplifies the oil & gas sector’s problems with an estimated $1.4t of bonds and $1.6t of syndicated loans in the oil & gas sector, according to the Bank of International Settlements. They warn of an “illusion of sustainability” that could quickly turn toxic as the credit cycle unravels. Much of this stress is US focused and this week, Standard & Poor’s took actions on ratings actions on 45 junk-rated energy exploration and production companies – and four exposed US banks – to reflect “material decline in credit measures due to lower prices and production as well as liquidity risks”.

To go back to our original question, the answer is increasingly looking like yes – we could get to the point where negatives outweigh the benefits. What balancing effect there is from cheaper oil should prevent a sustained global downturn; but there is danger that if prices remain as this level and as stress builds, investors spill out their assets into increasingly unsettled and nervous markets.

I should co-co

It doesn’t take too much effort to join these dots to create a more difficult picture for banks in 2016. Direct exposure to the energy sector seems manageable. European banks could face losses of up to $27 billion, according to Alastair Ryan of Bank of America Merrill Lynch. That’s 6% of industry pre-tax profits over the next three years. It’s this contribution to the decline in market confidence, liquidity, inflation that’s the greater worry. Negative rates – an effective tax upon banks – are also spreading and diving.  Sweden surprised markets today by cutting interest rates to -0.5% rather than the expected -0.45. The ECB could go lower on deposit rates in March. There’s even talk of the Fed going negative by the end of the year.

All this invariably puts pressure on profits after investors had turned to banks – Eurozone banks in particular – due to amount of official support and hopes of local economic revival.  These last few weeks have highlighted earnings weaknesses that weren’t in the forecasts. Thus, some pressure on bank shares and bonds is understandable. What is surprising is the extent of this pressure that goes beyond a reality check. Focus has turned to banks’ co-co bonds, contingent convertible bonds, which allow banks to skip interest payments without default and convert into equity in times of stress. These generated returns of about 8% in 2015 – all given back in 2016. But, then again,  stress absorption is what co-cos were designed to do and, unlike 2008, European banks have access to ample sources of short-term funding.

Is red the new amber?

The spread between twoand 10-year Treasury yields fell below 1% on Wednesday for the first time since the start of January 2008.  An inverted US yield curve – when this measure turns negative – has been a precursor of every US recession since the Second World War.  Another signal to run for the hills, or do we need to think differently in a low-to-negative interest rate world? US bond yields will inevitably be dragged down by low yields elsewhere, if markets don’t think a rate rise is imminent – and there was nothing in Janet Yellen’s speech yesterday to say so.  These are times of unprecedented low yields – Japan’s 10Y bond in the red for the first time – so do we need to rethink our interpretation of the signals?

Is selling the new buying?

How can companies get ahead of the curve in these markets? Roughly half of the 900 companies surveyed for our Global Corporate Divestment Study are considering a divestment in the next two years. That’s a relatively high number, but obviously companies have some portfolio adjustment to do after last year’s M&A spree and they know divestment can be hugely beneficial to their performance. In our survey,  84% of respondents thought that their last divestments had created long term value in the business.

Most of the focus in the media is on the buy-side and the positive impact – or otherwise – the deal will offer to the acquirer.  What’s too often forgotten is the positive impact a divestment can have on the seller’s performance. Based on our research, we’ve found that for strong companies – those that outperform their index – the more transformational the divestment, the greater the stock price outperforms. There are also positive effects for EBITDA and revenue growth too. Although, only 19% companies we surveyed felt they met key success criteria, suggesting that there is room for improvement. There is  also trend towards more opportunistic sales – which is tempting in these markets; but our research shows that sellers will achieve better value if they plan for disposal, sell before they are forced to act and if they plan for the use of the proceeds.

 


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