Key Private Bank publishes periodic updates on sectors of the economy they cover from an equity research standpoint. In one of their latest publications “Key Perspectives: Energy Outlook March 2016 – Revisiting Lower For Longer” Stephen Hoedt wrote an update on his publication from November regarding the duration of the oil and gas supply glut. He admits being surprised by both the steepness of the price decline (he thought it would bottom at $45/BBL) and the duration of the trough. He now sees the decline lasting into 2017 and also sees $30/BBL oil in the first half of 2016.
His thesis for the recovery turns on converting debt financed production into equity based production. The latter is like a wife of 40 years; dependable, predictable and patient. The former is like an insistent mistress; attentive, insecure and expensive. “Highly leveraged producers literally pump each other into the ground with additional supply in an attempt to be the last man standing, but most will ultimately fail.” Mr. Hoedt believes once the debt burden converts to equity through bankruptcies and reorganizations, oil and gas production can become rational again. Only then can producers afford to wait for the right pricing environment.
While I have always understood the macroeconomic concept of debt being deflationary, I have never seen it play out on a world wide scale. The whole expansion of capacity in the oil and gas energy business has been powered by insistent mistresses. From emerging nations like Nigeria whose political stability is tied to oil exports to established economies like Russia and Saudi Arabia, the world needs the oil to flow to satisfy uncompromising debt amortization and public promises. It is quite Darwinian- produce of perish.
It is not just the oil and gas industry that is highly leveraged. Debt to GDP ratios for almost every country and every industry have ballooned over the last 10 years.
Predicting the outcome of this long affair with an insistent mistress is impossible given the complexities of the geopolitical and macroeconomic landscape. However, the trend is unmistakable. We will likely have deflationary tendencies for the foreseeable future. The miracle of leveraged growth in commodity asset classes, in part spawned by a low interest and high liquidity central bank playbook around the world since 2008, is now giving way to deleveraging and deflation in the value of those asset classes. Prices will fall because the creditor has to be paid.
I never want to bet against the Fed and I am hopeful that we will inflate to make the debt payback more manageable but in case the Fed loses this battle, these are a few things you should keep in mind for leveraged business models like private equity in a deflationary scenario:
- Valuations should be based on free cash flow not how much you can borrow. If you are overpaying for cash flow streams with borrowed money, you will likely lose your equity in a deflationary environment.
- Interest rates on bank debt are often variable. Swaps can shift a portion of your variable debt to a fixed rate but there is always the risk that your counterparty in the swap will default at exactly the moment you need his balance sheet to support yours. For the highly leveraged oil patch, as asset values fall and covenants are breached creditors will demand higher interest to compensate for risk. Even small increases in interest rates may create wholesale defaults for marginal credits.
- Capital structure matters. Some margin of safety and staying power can come from over equitizing your portfolio.
- If your business model is tied to mandatory capital expenditures, a leveraged model in a deflationary period is toxic. The real value of debts rise as incomes and prices fall. Cash flows for growth cap x are all shifted to short term amortizations.
- Business models that rely on high labor content may be in trouble because most employers will cut workers rather than reducing wages. A consumer powered economy may shrivel in the face of resulting unemployment. We saw this in 2008 and 2009 as unemployment spiked.
I believe central bankers are more worried about the deflation scenario than we know. The recent conversations about negative interest and banning large denomination currencies are an indication their playbook may be shrinking.
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