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Mo Oil Mo Problems: Energy Spreads and Oil

Oil and energy have been in the spotlight recently as oil prices have fallen drastically since June. The U.S has experienced an energy boom as of late. Production of crude oil, natural gas liquids and dry natural gas has increased substantially due to shale drilling. Liquids production has grown the most this year, as U.S. crude oil is up 16% and natural gas liquids production has increased 13%. OPEC overall, though primarily Saudi Arabia, has decided to maintain current production levels and ride prices down in order to maintain market share. They hope lower prices will make it difficult for capital intensive oil exploration ventures in other regions to break even or sustain profitability. 

In the chart below we can see 5YR USD and EUR BBB Energy Z-Spreads, the spread above the risk-free rate, year to date. Throughout the year USD energy spreads have tightened until late August. In Europe we can see energy spreads faced significant volatility as various geopolitical events such as the Crimea conflict and ISIS situation have led to greater uncertainty. Brent has remained steady throughout most of these events with prices remaining above $100. However, oil prices started a decline in June. As this drop in Brent prices continued we started to observe a strong rise in energy sector z-spreads, which reached 2nd half highs in the U.S. and Europe of 1.36% and 1.34%, respectively, on 11/7/14

We can also look at how strong correlations between oil prices and credit spreads have been throughout the year. In the U.S. the negative correlation between oil prices and energy spreads has increased throughout the year as oil prices have moved to extremely low levels, with a -.93 correlation within the last 2 months. In Europe, correlations during the first half of 2014 were positive due to geopolitical events, namely the Crimea crisis. As tensions have somewhat subsided, correlations turned negative along with lower oil prices as noted with a -.78 correlation within the last 2 months. At these sustained low oil prices there is a strong negative correlation to energy credit spreads due to the capital intensive investments required and their need for higher commodity prices for profitability. This correlation is reduced when oil prices are at normalized levels. How high will the spread go? It all depends on where oil prices will be. 

For more information on the energy sector please take a look at our last edition of Sector IQ: Energy.

And for broader trends on the fixed income markets, read the latest edition of Fixed Income IQ: Corporate Credit Markets.

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