The oil price has been a primary focus this year with three main schools of thought about its importance and impact on markets. The first sees falling prices as a negative for equities, because falls reflect weakening demand for commodities as a result of a coordinated global slowdown in economic growth. The second views energy prices as a quasi-tax and expects stronger economic growth as a result of price falls, with the overall impact on equities beneficial despite the carnage in the energy and basic materials sectors. The third school sees most things as a function of excessive global debt, exacerbated by central bank policy and treats an oil price fall as a consequence of the inevitable over-capacity that results from mispricing credit.
Whichever camp you are in, OTAS tracks the indicators that foretell of any recovery in equities linked to energy and commodity prices, whether this has to do with suppliers going bust, improving demand or tighter monetary policies (okay, maybe not the last one). The oil producers considered most at risk are the shale field producers of North America, where production costs are high and leverage even higher. The median credit default swap for North American companies is 280 bps (remember European banks are around 105 bps).
Option market implied volatility, a measure of uncertainty, has reduced from a peak five weeks ago, but remains elevated compared to recent history and suggests that the average energy share could rise or fall 25% over the next three months. Investors are asking whether they can afford that volatility, but also whether they can afford to miss out if the sector were to rally so much.
There are some very small stocks impacting the analysis above, but the median large cap stock is still predicted by those with skin in the game to move +/- 20% by mid-June. Companies such as Williams, Continental Resources and Baker Hughes are expected to move at least 50% more than average. Exxon, Chevron and Schlumberger, in contrast, should be relatively sedate.
Short interest provides a third risk indicator for the sector. While short interest is back at the average level of the past two years overall, for the large caps there is a clear upward trajectory, in spite of the recent pullback. This is in keeping with broader market reports, such as CFTC data, that short covering has not been a feature of the recent equity market rise.
In Europe, the risk indicators for Energy are more benign. This is because there are fewer wildcat operations listed and as Europe lacks the deep option, CDS and short interest markets that define the US. Credit risk among Europe’s energy giants is a little over a third of the North American average and barely differentiated from Europe’s banks. Short interest is at relatively low levels and implied volatility suggests stock moves of +/- 15% in the coming three months.
All of this suggests that acute problems in the Energy sector are a peculiarly US trait, as a function of the high borrowing and extraction costs of multiple smaller oil producers. Both sectors yield a similar amount at around 4.3% 12 months’ forward, although US large caps promise only 2.8% as a reflection of their haven status within a troubled industry. European energy equity investors are happy to ride out low oil prices, comforted that the income from their holdings is a rare bonus in an environment of ever-lower interest rates.
None of this should provide grounds for complacency and OTAS continues to track individual names to see where risk is hiding. One particularly powerful analytical tool is divergence, a bespoke measure of by how much equity prices are divorced from the other risk indicators of credit, option volatility and short interest. Do you have a holding that is becoming riskier faster than its peer group; contact us to find out.