The Bloom Is Off the Rose

I’ve written here before about how cheap oil is wreaking havoc in the junk bond market, but I just read a story about the darling of asset managers everywhere in this sector, Exxon Mobil, and it appears the bloom is off the rose.

Big oil companies have been a staple in pension, mutual, and hedge funds alike forever. Their business model has been: “Find as much new oil as you sell each year, mark the newly discovered fields as future revenue on your balance sheet, then reinvest in searching for more.” It has generated predictable and reliable returns for investors everywhere. Until 2014.

That’s when it became clear the global economy, and China’s in particular, was stagnating. Oil went from over $100 per barrel to under $40. If this sounds familiar, that’s because the same thing happened about six months before the Global Financial Crisis hit in 2008.

Cheap oil puts a big hurt on oil company profits, especially when it goes down as it has, and stays down for two years! But even though big oil companies like Exxon Mobil are one of the largest positions in almost every mutual and pension fund out there, and cheap oil is bad for their margins, by itself, it isn’t enough to bring the rest of the stock and bond markets down with them.

Enter Congress and the Federal Reserve. In response to all the other economic and market crises over the last fifteen years, Congress and the Fed have pumped tsunamis of cash into the bond market, driving prices off-the-charts higher than they’ve ever been, and yields off-the-charts lower than they’ve ever been.

All this cash and debt has found its way into the energy sector and especially into American oil companies. Most of what I’ve read up until now has related to the impact cheap debt and oil have had on the small exploratory American oil companies. The companies that rose from the birth of new, more aggressive oil exploration and extraction technology like fracking have been devastated by cheap oil, and in many cases are “zombie” companies, kept half alive by cheap debt. Junk bonds and oil companies are frick and frack now.

Now we’re talking about a real recipe for a broad market downturn. But it gets worse. Or, better, depending on how you look at it.

With the Paris accord on climate ratified in December 2015, the pressure on oil company profits is more intense than ever, and the investment world is finally waking up to the fact that governments have been pressed to move beyond lip service to slow climate change. Begrudgingly, kicking and screaming even, governments and Exxon Mobil are acknowledging and agreeing to reducing carbon emissions. For the first time ever—primarily due to the proceedings brought against them for keeping evidence of climate change under wraps for decades—Exxon Mobil has put forth a plan to reduce their carbon emissions.

In classic spoiled child style, instead of owning up to their bad behavior long ago when they could have saved face, they hid it until they got caught in their lie. The company renowned for decades as the best run oil company in the world is being assailed by its biggest investors who are clamoring for voting control as profits plunge and the company’s debt load quadruples. For the first time since the 1930’s Exxon Mobil’s debt rating has been downgraded below triple A. Junk bonds may not be just for the little players anymore.

All of this throws everything about the energy sector and bond markets as we’ve known them into question. And if you’re an “efficient markets” proponent and you think this is already baked in the cake, you’ve got another thing coming. While a bit off its all time high price, Exxon Mobil still trades at a robust premium. To the biggest stake holders at Exxon Mobil, the bloom is truly off the rose, but as usual, the pension funds, mutual funds, and mom and pop investors who hold it will likely be the ones left holding the bag.