Ivan Abreu/SOPA Images/Sipa USA via AP Images
Passengers wear protective masks in an near-empty departure terminal hall at the Hong Kong International Airport, February 17, 2020. Drastically lower transportation needs, including air travel, as a result of coronavirus fears, could damage the energy sector.
We’ve been talking a lot about the supply shock from the COVID-19 coronavirus. Manufacturing slowdowns in China have seized up supply chains around the world, and as other countries, including the U.S., see cases increase, more disruptions could result. That means shortages at the neighborhood drugstore or electronics store, or even on Amazon. The economic consequence of having nothing to buy is obvious, with dramatic, unforeseeable political implications.
But what about the economic consequence of having no customers? Coronavirus has ushered in a demand shock that is already roiling markets. When China, home to the largest consumer base in the world, goes on lockdown for more than a month, nobody there shops at stores for discretionary goods like luxury items. Nobody goes out to eat. People work from home, and don’t turn on the lights or the air conditioning at the office. And perhaps most important, nobody travels to work, and factories don’t use any energy.
This demand shock for energy could resurrect a persistent risk in the economy that hasn’t yet manifested: a years-long surge in corporate debt. This has been perennially singled out as what will lead to “the next financial crisis,” but I’ve always been skeptical. The corporate debt market simply isn’t big enough and does not spur enough investment, on its own, to trigger a recession. Besides, interest rates are historically low, putting private balance sheets in pretty decent shape.
But guess what? The energy sector happens to be the most highly leveraged part of the corporate debt market. When a downturn hits, indebted companies may not be able to pay back loans or roll them over.
A corporate debt default wave could accelerate or deepen a recession driven by other factors, like COVID-19. It’s a relatively overlooked but important element of the crisis we could be facing.
There are positive by-products from the Chinese demand slowdown; within the first month of quarantines, China cut its carbon dioxide emissions by an amount equivalent to what Chile emits in an entire year. But the reduction of 20 percent of oil demand per day in China depresses oil prices, which hit their lowest level since January 2019 and fell again on Thursday. Oil demand will decrease this quarter for the first time since the peak of the Great Recession in 2009. Revised energy forecasts see this as a temporary normal, with lower prices, and consequently lower returns.
OPEC has cut output and may do so again next month. But there’s a persistent oversupply, a glut in the market, which will take lots of time to work through. The lack of transportation travel alone, which ranges from millions working from home to extremely reduced air travel, ensures that oil demand will stay low.
That’s bad news for the small companies drilling in the U.S. that need to turn over their supply to cover debts. Oil and gas bankruptcies for small drillers have been elevated for some time; dozens have filed in the past two years. In August 2019, the default rate on low-rated energy bonds (sometimes called junk bonds) was 5.7 percent. That was when oil was trading at $60 a barrel; now it’s at $46.
“In terms of energy, we’re definitely more exposed because we’re much more of a producer than we’ve ever been,” says economist Jared Bernstein of the Center on Budget and Policy Priorities. U.S. wells are newer than those in the Middle East, and were more expensive to build. Therefore, lower oil prices translate into much lower profits relative to legacy costs.
This is just as bad for natural gas, if not worse. A briefing note released right before widespread pickup of COVID-19 noted that 42 U.S. fracking companies hit bankruptcy in 2019, and there’s $100 billion in debt left to roll over in the next few years. The sector, hit when prices slumped in 2015 and 2016, could take years to recover from this demand shock. It would be great to take this opportunity to green America, but the lithium-ion battery and solar panel sectors are primarily sourced in China, and those factories have been shut.
The fact that the companies most exposed to high-cost, risky debt happen to be in the sector that’s most sensitive to the demand shock we could be facing makes the corporate debt bubble more ominous than I’ve ever seen it before.
It’s certainly conceivable, amid low demand, that oil and gas companies won’t be able to earn enough in the near term to cover their heavy debts. Markets certainly expect it; energy bonds have weakened considerably. That’s bad for two groups of people: domestic oil and gas producers, and whoever on Wall Street holds their debt.
(I recognize that these are not necessarily sympathetic actors!)
However, we don’t have a great sense of the identity of those specific debt holders. Could it be lurking within some deeply connected player within the financial system? Just because the debt may not have pooled within a large investment bank doesn’t mean that such banks aren’t tied into the system. “That’s the right way to think about this—interconnectedness,” Bernstein says. “I’ve long maintained that’s the key variable regarding shocks, more so than size.”
Defaults in the energy market could also lead to interest rate spikes within other parts of the corporate junk bond market, as lenders try to compensate. This puts pressure on companies with elevated debt. Much of our retail and restaurant sectors—which are also not poised to do terribly well amid a pandemic crisis—are in the hands of private equity firms that have placed large amounts of debt on their portfolio companies.
The fact that the companies most exposed to high-cost, risky debt happen to be in the sector that’s most sensitive to the demand shock we could be facing makes the corporate debt bubble more ominous than I’ve ever seen it before. Corporate debt defaults were never going to take down the economy. But in the event of an unrelated downturn, the fact that these companies are debt-laden could deepen the hole. Particularly as the energy sector is regionally focused, it could return us to a series of mini-recessions in key parts of the country, with unpredictable social and political consequences.
There’s also the possibility that a recession is just a recession, and the state of the market before it hits matters little. But this long-hyped corporate debt story, which never made much sense, could finally play a role now, thanks to a few unhappy coincidences.
