News & Analysis

From the depths of a sustained downturn that followed the oil price bust of 2014, US West Texas Intermediate (WTI) crude has staged an impressive rally to return to the $100 watermark for the first time in nearly eight years. 

But the relationship between the commodity benchmark and Oil & Gas loans in this latest leap higher has notably broken down. 

Through March 18, US West Texas Intermediate crude was up 39% in 2022. The market value of loans backing companies in the Oil & Gas sector, by contrast, had lost 1.16%. 

On a price basis, LCD data from the S&P/LSTA Leveraged Loan Index shows the weighted average bid of Oil & Gas loans slumped 52 bps from the end of February through March 8, despite crude jumping by nearly $28 a barrel, to 123.64. Since then, while the underlying commodity price has fallen, Oil & Gas loans have partially rebounded in line with the broader loan market. 

Through March 18 of this year, oil prices rallied by $29 (nearly 40%) as loans referencing the sector lost more than 112 bps. 

Hot commodity

Since 2007, the correlation of daily Oil & Gas loan prices and WTI prices, at a value of 0.78, illustrated a significant positive relationship between the two. However, from the start of this year through March 18, this correlation not only weakened, but inverted to negative 0.70, illustrating how the two have gone their separate ways.

There are a number of reasons why loans in the sector have not capitalized on $100 oil. For one, the war in Ukraine has considerably dented valuations in the leveraged finance markets, dragging loans and high-yield bonds into the red, and therefore outweighing the benefit of rallying oil prices. 

Indeed, the broader loan index had returned negative 1.93% on a market value basis, or negative 1.1% on a total return basis, through March 18 this year. In high-yield, as is typical in risk-off environments, the losses have been even worse. According to the S&P US High Yield Corporate Bond Index, the asset class was down 5.14% through March 18.

Furthermore, Oil & Gas loan bids have averaged roughly 97 in 2022, leaving limited upside in terms of price appreciation in the approach to par—at which point the risk of a repricing or prepayment increases.

By comparison, when oil prices rallied from the 2020 trough, loans backing companies in the sector were sitting at highly distressed levels, in the mid-50s, and lower. Buyers of distressed loans, given the higher restructuring risk, will typically invest on expectation of recovery values, knowing that underlying oil prices are a big part of the enterprise value, as opposed to the par market, where pricing is more relative to an underlying floating-rate benchmark.

With all that said, the performance of loans is unlikely to be tied to expectations that either commodity will see plunging prices in the coming months. The US Energy Information Agency in a March 16 report released a forecast for the price of WTI to average $113 a barrel in March and $112 a barrel for the second quarter of 2022.

"Our forecast is subject to heightened levels of uncertainty due to various factors, including Russia's further invasion of Ukraine, government-issued limitations on energy imports from Russia, Russian petroleum production, and global crude oil demand," the agency's statement reads.

For natural gas, the agency expects the Henry Hub price will average $3.83 per Metric Million British Thermal Unit in the second quarter, and $3.95 per MMBtu for all of 2022. This compares to a five-year average of $2.97.

Where oil price matters

Bookending the prior chart is the advent of $100 oil. In the in-between periods, the tighter correlation in periods of distressed pricing of loans below 80 cents on the dollar is clear to see.

Zooming in to the late 2013 to mid-2014 period, the correlation of Oil & Gas Loans was a relatively weak 0.35. 

As mentioned previously, this new era of $100 oil has correlated negatively to the price of loans backing companies in the sector.

In high price or low price environments—as instrumental as this industry segment is to global economic health (since big moves in oil can cause serious disruption to assets in many sectors)—the sector has a relatively limited impact on the broader loan market. Following the winter 2014/2015 oil price crash, the differential between the average bid of Oil & Gas loans to the broader index (excluding oil) widened to 45 points in February 2016 as bankruptcies in the sector skyrocketed. Average bids of all loans in the index followed closely to index levels that excluded Oil & Gas loans during this sector-level default wave. Of note, the share of Oil & Gas in the S&P/LSTA Leveraged Loan Index is now just 2.4%, down from 4.4% at the end of 2014. By comparison, Oil & Gas makes up around 12% of the S&P US High Yield Corporate Bond Index.

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