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Date:
Author:
George Flynn and Mark Remington

Trump’s battle cry to increase oil production has been met with a collective shrug, but what does it mean for High Yield Credit?

George Flynn, Global High Yield Bond Fund Manager

Mark Remington, Global High Yield Bond Fund Manager

There has been a fair amount of press in the last few days pointing to Trump’s promise to get USA oil prices and prices at the petrol pump lower. His election reflects in a (large) part voters’ dissatisfaction with high inflation and a squeeze on living standards.

A lot of the pushback on Trump’s “drill baby drill” rhetoric is that he will be effectively asking the turkeys to vote for Christmas. The ‘turkeys’ here are the oil producers and rather than the seasonal chop, ‘Christmas’ here is lower oil prices.

West Texas Intermediate is currently trading around $71/barrel, and this means current production is economical whilst new wells are at risk of becoming uneconomical.

Chart 1. Breakeven oil production cost $ barrels of oil equivalent

 

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Source: Statista https://www.statista.com/statistics/748207/breakeven-prices-for-us-oil-producers-by-oilfield/ as at 19 December 2024.

However, global supply and demand is expected to remain marginally in net supply in 2025 c.0.4 -0.6 million barrels of oil equivalent per day (BOE/d), and this has improved c.0.5 million BOE/d post OPEC+’s decision to hold back on increasing market supply, due to lower Asian demand.

So, in a world of net positive supply, more production would depress prices further and make new wells uneconomical.

Add to this the impact of potential tariffs on Iran, which produces c.1 million BOE/d, and it is easy to see how the immediate outlook for oil prices in the first quarter may temporarily be to the upside.

Risks to the downside stem from sanctions on China, Mexico, Canada and an end of the war in the Ukraine.

All this is to say, that oil producers will likely wait, like OPEC, to see how the dust settles before making any decisions to ramp up production. And even if they do, there will be a lag between planning, building and production.

Here is a nice chart of US rig count versus crude oil prices – can you spot the pattern? Interestingly US production is at all time highs, but the rig count is close to lows.

Chart 2. Rig count and oil prices move together

 

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Source: Bloomberg (BAKETOT Index), Baker Hughes as at 19 December 2024.

 

Chart 3. US crude oil production has grown to 13.6 m bpd

 

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Source: Bloomberg and US Department of Energy as at 19 December 2024.

Oil companies have been focussing on capital discipline – trying not to spend too much and using that money to shore up balance sheets or return it to shareholders.

This has been a net positive for high yield energy. It has already seen a large cohort of over-levered companies go bankrupt during the pandemic and as such the remaining issuers are relatively healthy from a lender’s perspective.

Table 1. CCC exposure is tiny compared to pre pandemic

 

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Source: ICE Indices H0EN, HY Energy index as at 19 December 2024.

High yield energy declined faster than that of the HY universe during the pandemic, in part due to defaults exiting the index and due to balance sheet repair. Leverage is beginning to normalise now.

Chart 4. Energy HY median leverage has outperformed HY leverage (indexed at 1, compounded quarter-on-quarter % change)

 

Chill5.png

Source:  Bloomberg BI as at 19 December 2024.

Unlike leverage, high yield energy free cash flow (FCF) to debt remains elevated, albeit lower than during the pandemic. Cash to debt is lower than average, as shown in the chart below.

Chart 5. High yield energy FCF to debt remains elevated

 

Chill6.png

Source:  Bloomberg BI as at 19 December 2024.

But “Drill Baby Drill” is not only about getting more domestic oil out of the ground, it is also, as is Trump’s wider want, a bonfire of regulation. De-regulation, fast tracking of permits and further opening land available for purchase and development will have a positive impact on oil companies’ bottom lines. Again, this is likely to take time to feed through the system even with day one presidential action.

Net-net, if HY energy companies, particularly those exposed to liquefied natural gas as well as oil, maintain their capital discipline and oil prices remain range bound then they will likely do well.

If prices do decline, at an aggregate level at least, there appears to be headroom both in terms of leverage and FCF to absorb some of the decline.

 

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