Energy & Junk Bond ETF Investors Fret As Oil Swoons

March 10, 2017

For the first time in 2017, oil prices fell below $50/barrel, infusing a bit of concern into a stock market that hasn't had much to worry about so far this year. WTI oil futures were last trading around $49, down 8.9% on a year-to-date basis.

Oil's sudden move lower is somewhat reminiscent of last year, when prices shockingly plunged to a 13-year low of $26. Prices today are a far cry from those lows registered last January and February, but they've moved swiftly enough to raise the pulse of an otherwise-subdued market.

ETF Losers From Oil's Swoon

The drop has put pressure on oil ETFs such as the United States Oil Fund (USO), down 11.3% year-to-date; broad commodity ETFs such as the PowerShares DB Commodity Index Tracking Fund (DBC), down 5.5% year-to-date; and energy equity ETFs such as the Energy Select Sector SPDR Fund (XLE), down 8.3% year-to-date.

Indeed, the energy sector―as measured by XLE―is far and away the worst-performing stock market sector of 2017 so far. With the exception of telecom, no other sector is in the red for the year.

Sinking oil prices have also had a detrimental effect on another market: junk bonds. Since oil's descent began a few weeks ago, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) lost 2%. Granted, HYG is still up 0.9% year-to-date, but the wind has clearly been taken out of its sails as investors imagine a scenario, much like last year, where energy-sector defaults tick higher as oil prices continue to fall.

In 2016, U.S. energy companies defaulted on $39 billion worth of high-yield bonds, according to Fitch, pushing the overall junk bond default rate to a seven-year high.

YTD Returns For USO, DBC, XLE, HYG


US Production Negating OPEC Cuts

Whether a scenario of even lower oil prices (and by extension, lower energy and junk bond ETF prices) comes to pass largely depends on the trajectory of U.S. oil production. Output in the country is rising fast on the back of a renewed drilling boom, negating supply cuts from the Organization of the Petroleum Exporting Countries (OPEC).

Emboldened by the recovery in crude prices since early last year, U.S. energy companies doubled the number of rigs they use to drill for oil and pushed U.S. oil production up to 9.1 million barrels per day, according to the latest data from the Energy Information Administration.

US Oil Production (thousand barrels per day)

The 650,000 barrels per day surge in U.S. oil output since last October offsets a big chunk of the 1 million barrels per day cut in OPEC production that the International Energy Agency reported for January. Those OPEC cuts―which will expire at the end of June―have proven to be ineffective. Just last week, U.S. stockpiles of crude oil hit a record 528.4 million barrels, flying in the face of the cartel's goal of reducing global inventories.

Throwing In The Towel?

Speaking at an industry conference in Houston this week, Saudi Arabia's energy minister Khalid al-Falih said that "the green shoots in the U.S. are growing too fast” and that Saudi Arabia will neither “allow itself to be used by others” nor “bear the burden of free riders.”

If Saudi Arabia and the rest of OPEC throw in the towel and decide they no longer want to prop up oil prices for the benefit of U.S. oil producers, they'll refuse to extend the production cut agreement beyond June. In that case, global supplies will quickly increase by at least 1 million barrels per day, pushing prices well below current levels.

In that bearish scenario, energy and junk bond ETFs will certainly feel more pressure. The broader stock market could also take more notice of oil, creating a head wind for funds such as the SPDR S&P 500 ETF (SPY).

Contact Sumit Roy at [email protected]


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