Giving Credit to the Growth Engine

 |  Includes: EPD, TBT, TLT, TPP
by: Elliott Gue

Far too many investors ignore the role that improving credit markets have played in the recent rallies in stock and commodities markets.

The financial media has spent considerable time discussing the 50 percent rally in the S&P 500 since the March lows and the doubling in oil prices since late last year. What commentators rarely mention is that crude and the S&P 500 have returned to levels last seen in October and early November 2008. Both oil and the S&P 500 would need to rally another 20 percent to the levels that prevailed before Lehman Brothers’ implosion and the height of the credit crunch. Viewed in that light, these moves don’t look quite as impressive.

In the last issue of The Energy Letter, Don’t Buy Oil Speculation, I spilled considerable ink dissecting the fundamental drivers that will propel oil prices higher in the coming years--chiefly, rising oil demand from developing countries and difficulties bringing new supplies to market. (Even as oil prices soared between 2004 and mid-2008, global producers struggled to bring new production online.) These issues are routinely ignored by those who focus solely on week-to-week US oil inventory numbers released by the Energy Information Administration (EIA).

To some extent, the recent rally in oil prices reflects traders pricing in these supply factors and a global economic rebound. But investors shouldn’t overlook the normalization of stock and commodity markets: The only reason crude oil ever traded under USD40 per barrel was because of the rapid shutdown in global economic activity that resulted from the credit crunch.

The real pricing aberration isn’t the current quote of USD70 a barrel but the extraordinary lows witnessed in December. With crude prices at USD40 or even USD50 a barrel, most global oil projects, especially outside OPEC, are simply uneconomic. In that pricing environment, exploration and development activity grinds to a halt. Even if we assume much lower US demand, this supply situation is untenable for any length of time; the decline in global oil production would quickly retighten crude markets.

Global credit markets aren’t likely to return to the free-and-easy credit days of mid-2007, nor would that scenario be prudent. However, credit conditions continue to improve, particularly in the corporate bond market. A continued normalization of credit conditions is behind a number of powerful investment trends in the energy sector.

There are a number of ways to monitor the health of the credit markets. Three indicators I watch carefully are the TED Spread, the yield on high-yield bonds and corporate bond issuance. First up, here’s a chart of the TED spread since mid-2006.

The TED spread is the difference between the yield on three-month US Treasuries and the three-month London Interbank Offered Rate (LIBOR). The three-month US Treasury yield is essentially a risk-free interest rate. LIBOR is the rate that banks charge to lend each other money. The more elevated the TED spread, the more pervasive the sense of fear in credit markets.

When yields in the interbank lending market are high relative to government bond rates that indicates banks are reluctant to lend money to one another. At the height of the credit crunch, there were times when essentially no interbank lending occurred at any rate. As my chart shows, rates really spiked starting in mid-September after Lehman Brothers collapsed--an event that called the solvency of the entire financial system into question.

Click to enlarge

Source: Bloomberg

The TED spread spiked to around 470 basis points (4.70 percent) in October and then settled around 100 basis points early this year--a healthier level but still elevated by historical norms. Since March, confidence in the banking system has slowly returned and the TED spread now stands at just under 28 basis points (0.28 percent). That puts the spread back down to the levels that prevailed in 2006 and early 2007.

The graph below traces the spreads on high-yield bonds.

Click to enlarge

Source: Bloomberg

This graph depicts the average yield on 10-Year corporate bonds issued by companies rated “B” by Standard & Poor’s minus the yield on 10-Year US Government bonds.

These bonds are known as “junk” issues because the underlying companies have less-than-stellar credit ratings. To compensate investors for the higher risk of default, junk bonds offer higher yields than government and higher-grade corporate issues.

In many ways, this graph resembles movements in the TED spread. Back in 2006 and 2007 B-rated debt typically yielded about 3 percent above prevailing Treasury yields and, at the height of the credit crunch, that spread spiked to 1,300 basis points (13 percent). Companies with lower credit rating were paying exorbitant interest rates to borrow money; in fact, the reality was that at the height of the crunch even the most creditworthy US companies could not borrow money at any interest rate.

This spread is still about double where it was back in 2006 and 2007, but yields on high-yield debt are falling fast. Although such issuers are still paying a hefty price to borrow money, it is possible for them to access the capital markets if necessary.

And companies are taking advantage of these improved credit conditions to issue bonds and raise capital. The following graph shows the total issuance of US corporate debt over the past few years and year-to-date.

Click to enlarge

Source: Bloomberg

As you can see, issuance of both investment grade and junk corporate bonds exploded from 2002 to 2007; the final two years of that period represented the height of the credit boom.

But last year the corporate credit markets contracted. In particular, issuance of high-yield debt fell off the proverbial cliff. Much of the debt sales that did occur in 2008 happened in the first half of the year before the fall crunch totally locked down the corporate bond markets.

This year, that trend has reversed in earnest. As of August 11, US companies had already issued more bonds than in 2009 than all of last year. And this doesn’t just represent the activities of a handful of highly rated companies--even high-yield issuers are raising capital via debt markets.

Clearly, some of the bond sales that would have happened in late 2008 were pushed out to 2009 as companies waited for friendlier market conditions; the pace of bond issuance will likely slow in the second half as pent-up demand abates. However, even at a more modest pace of bond sales, issuance will be robust.

How to Play it

Functional credit markets are a key support for the economy, stocks in general, and the prices of commodities. I also see improving credit conditions supporting an uptick in merger and acquisition (M&A) activity in coming months.

This is particularly true in the energy markets; the fall in commodity prices since mid-2008 has weighed on valuations for oil and gas-producing properties and companies. With access to credit improving, better-capitalized companies are in an excellent position to buy up quality properties at bargain prices.

This process is already underway among Master Limited Partnerships (MLP), a group I cover in depth with Roger Conrad in our new service, MLP Profits. MLPs, and their close cousins, limited-liability companies (LLC), typically rely on a combination of equity and debt offerings to fund acquisitions and new projects such as new pipeline construction.

These projects and acquisitions, in turn, allow MLPs to grow their distribution payouts; since most investors buy the group for tax-advantaged income, growing distributions underpin valuations. One of the reasons the group was hit last year is that investors were worried these companies would be unable to grow their distributions without access to capital.

But the acquisition growth engine is already restarting. Several major MLPs have announced new equity and debt offerings this year. The most recent debt offering from an investment-grade MLP priced at a spread of less than 200 basis points over Treasuries. That’s roughly what investment-grade MLPs were paying in early 2008, long before Lehman Brothers’ bankruptcy touched off the credit crunch.

MLPs are plowing this cash into acquisitions and new growth-oriented projects. Natural gas midstream giant Enterprise Products Partners (NYSE:EPD) struck a deal to acquire another MLP, TEPPCO (TPP), in late June in a $3.3 billion deal. This was an all-stock deal that wouldn’t have been possible a few months ago.

Even more recently, another partnership we follow announced the $118 million acquisition of oil-producing properties in the Permian Basin of Texas and New Mexico. The purchase price was around $9.80 per barrel of oil equivalent reserves, a significant discount to what the same property would have fetched in early 2008.

Still, at more than $100 million this is one of the largest purchases made by an upstream partnership since the credit crunch took hold in the latter part of 2008. The fact that the acquirer feels comfortable funding it via the company’s existing credit facility is a sign that credit conditions have improved markedly in recent months.

This uptick in merger and acquisition activity is another key support for MLPs and other energy-related stocks.