Back in March we demonstrated how much of a historical outlier recent energy stock prices are, when we showed the ridiculous forward P/E multiple associated with energy stocks, whose earnings have collapsed not only historically but also on a forward multiple basis, resulting in a 50+ P/E forward multiple: something unprecedented in history.
Overnight, Deutsche Bank recreated the same analysis in an even easier to digest chart, one which shows energy stock valuations based on an even more appropriate – because it focuses on cash flow – valuation metric, EV to EBITDA. As shown below, the US energy sector is now trading at a roughly 7x EBITDA multiple compared to a historical average between 1x and 2x. Notably, the bank also presents what the implied valuation is assuming $45 oil: roughly 3 EBITDA turns lower, implying the market is pricing energy companies on oil back in the $70-80 range, if not higher.
But more than just equities, the risk of a sharp repricing is just as evident in the junk bond space, where energy is by far the largest sector amounting to just shy of 16% of all outstanding issues.
As a result perhaps it is not surprising that the biggest driver to sharply tighter high yield spreads has been the recent rebound in oil prices, which has also led to a dramatic tightening in the HY index spread from north of 800 bps to approximately 600 bps today.
So while investors are hopeful that the recent ramp in oil may continue (unless it follows the pattern set in the summer of 2015 when oil likewise pushed higher all summer, settling at around $60/bbl before plunging at the end of the year), one key catalyst may force a sharp repricing in not only oil, but also the junk bond market as well as energy stocks: the Fed.
As DB shows in the chart below, the biggest correlation (if not direct causation) to lower oil prices over the past year was the stronger dollar, which having eased in recent months thanks to the Fed’s recent relent, has allowed oil to rebound. However, if indeed the Fed is again set on tightening financial conditions, what will happen to the dollar, whether DXY or trade-weighted, and how will this impact the price of not just oil, but the HY and equity market as well? To Deutsche Bank the answer is “not good.”
But even if the US Dollar doesn’t jump substantially from here, DB calculates that oil is already 20% higher than the fair-value level implied by the USD.
Furthermore, oil has overshot not just the dollar, but the “recovery” in global macro surprises as shown below, also by roughly 20%.
Another risk: the China-driven plunge in metal prices will sooner or later spill over into crude:
Finally, there is positioning: as of this moment, net spec Brent long as close to two-year highs. The implication is that once the selling begins in earnest, it will only accelerate as those who wanted to get long already are, leaving few natural buyers in any selloff.
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