The Lesson of Oil

I've said it on here a couple of times about high yield debt markets. O&G now constitutes about 20% of HY debt (previously, before fracking and Midstream booms, it was in the mid teens).

With a significant portion of these E&P companies levered up substantially, facing a high level of commodity downside exposure due to aggressive approaches to hedging (e.g., 3-way collars with floors well over $60), there is going to be some serious movement in that space.

The effects are going to be far reaching and could put upward pressure on cost of capital for everyone, leading to dovish sentiment at the Fed, translating to further delays in any meaningful pickup in rates in 2015.

Interesting times we live in.

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and could put upward pressure on cost of capital for everyone

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I followed you until here (well, except knowing what a 3-way collar is). But why would the E&P companies being highly leveraged drive up the cost of capital for companies in other industries?

Please take my extremely unqualified opinion with a grain of salt. If anyone disagrees please call me out.

I say that because yield spreads over Treasurys (which is often the baseline) have widened because there has been a significant selloff among institutional investors of high yield debt. The fact that over 20% of applicable issuers is under severe pressure means that high yield debt in general is going to be weighed down in the short term, regardless of whether or not that's justified.

Cost of capital is derived from 2 elements: cost of debt and cost of equity. A major impetus for quantitative easing and keeping rates low in general is that it makes the economy's cost of capital lower.

One disclaimer, I was probably remiss to say "everyone". This really won't apply to companies that don't need access to hy debt, aka large caps, blue chippers, etc.

Re 3 way collars, derivatives aren't really my area of expertise (but then again nothing is), but in very broad terms, it's when firms take on additional downside risk to try to offset the cost of hedging under the premise that there's basically no way oil drops below 70, 60 etc. They aren't completely naked but there is a lot of risk to cash flows, which increases default risk.

Good stuff Houston, thanks for posting.

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Most people easily grasp the immediate impact of developments, but few understand the "second order" consequences... as well as the third and fourth.

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This is what separates the Herd from the professionals. But trying to figure out the third and fourth order consequences when, say for instance, the Fed raises interest rates, can lead to a 'this is your brain on drugs' situation. Then, even if you have it all figured out, the market can stay irrational as well.

I agree with the author, coming out of the Tarp hangover with the third and fourth order consequences of oil prices and the probable rate increase from the Fed, 2015 is going to be an 'exciting time'. This is not your Father's market anymore.

Well in the long term that does make sense, and my inclination is that markets will normalize to reflect what you are saying. But in the short term, the downward pressure is going to cause a selloff of institutional money (etfs, mutual funds, etc.) that will drive down bond prices and drive up yields.

frick les miles btw

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It also spells out something else i believe - that the average individual investor is irrational.

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At least the little guys have an excuse. The pros are fricking nuts, too, and they're supposed to know WTF they're doing.