The importance of high-yield markets
Their role in fuelling the success of the US shale industry offers lessons for India’s economy today
When one studies the evolution and growth of the shale industry in the US, one realises that it is a truly amazing success story. A triumph of entrepreneurship, technology, regulatory forbearance and private property rights. A bunch of wildcat drillers took the risk and were backed to the hilt by the capital markets. Largely due to the boom in shale oil or tight oil, US oil production, which had peaked in 1970 at 10 million barrels per day(mbpd), has hit new highs in the last few years. After declining to 6 Mbpd in 2008, US oil production reversed course to reach 12 Mbpd in 2019. The surge in production, which is entirely due to shale, has given the US energy independence and changed the economics and geopolitics of the petroleum industry. Today, US shale oil is the price-setter and produces the marginal barrel of oil.
The initial impact of shale was on natural gas, where it drove prices to new lows and spurred the consumption of gas for power, reducing the dependence on coal.
Whichever way you cut it, shale has been a huge positive for the US economy, boosting capital expenditure, improving energy security and lowering the cost of manufacturing.
What many do not know is the integral role the capital markets, especially debt and high-yield markets, had in enabling the shale revolution. Oil and gas high-yield issuance really took off in 2010 at the outset of the US shale oil revolution. Shale had been enabled by the decade-long rise in oil prices, which peaked at $150/barrel in 2008. Between 2010 and 2014, we saw over $510 billion of high-yield debt issuance by the oil and gas sector, peaking at $160 billion in 2014. Issuance then stabilised at approximately $100 billion per annum between 2015 and 2019. So, a trillion dollar was raised over the last 10 years. Taking into account the average tenure of issuance, there is about $640 billion of high-yield debt still outstanding today (source: Dealogic).
The controversy in the space today is over the refinance risk on all this high-yield debt. More than one-third, about $222 billion, will come up for repayment in the next two years. If the high-yield market does not support, we will see a wave of bankruptcies and well shut-ins. Already so far in 2020, high-yield issuance for the energy sector has dropped significantly, with only $30 billion issued to date. The high-yield markets will, in effect, decide the long-term future of the industry. With no or limited funding, there will be no future growth in drilling and production. With no new drilling, shale oil production will drop, given the depletion rates of older fields.
Shale would never have reached scale without the debt markets. Banks on their own did not have the risk appetite.
Now why is all this relevant to India? Beyond the obvious sensitivity to oil prices, as shale oil production declines, oil prices will rise, negatively impacting the Indian economy.
However, the longer-term lessons are in trying to understand the importance of high-yield debt markets, and the critical role they can play in building our infrastructure and new industries.
In India today post the IL&FS debacle, the failure of Dewan Housing and the closing of the Franklin corporate bond funds, there is no longer much of a high-yield market. Trading volumes have collapsed, and it is difficult to issue any new paper. This is even though many in India characterise any instrument with a rating below AA as being high yield. The genuine high-yield instruments below investment grade rating(bbb) have almost no market or trading at all.
We have to find ways to revive the high-yield markets (anything below AA rating), if we have to reduce our dependence on the banks. The sad fact remains that at present 60-65 per cent of our financial system, all public sector banks (PSBS)— excluding the State Bank of India— most non-banking financial companies and most smaller private banks are in no position to lend. Either they lack capital, funding, risk appetite or management. Coming out of Covid, we will only have five to six large banks which will have the willingness and ability to lend. All of them are raising capital as we speak, soaking up whatever capital the markets will give. For growth to ever revive in the economy, we need more sources of capital than these six banks. These banks will all do phenomenally well, but they cannot support the growth of the entire economy. It is a well documented fact that our growth slowdown is closely related to the financial system stress of the past few years.
There are numerous reports and suggestions on how to revive the bond markets. From increasing the pool of eligible players and eligible assets, to bringing in more foreign portfolio investment and encouraging retail flows. These steps and more must be taken quickly. A period of low rates may also help, as the search for yield may change risk appetite among institutional players as they have no choice but to move further out on the risk curve to meet target or promised yields.
A vibrant bond market, both investment grade and lower credits, is critical to help the economy come back on the rails. No bank today wants to take large chunky corporate exposures. No bank wants to fund infrastructure or green-field projects. All the six relevant banks have promised their investors that they will not increase the risks they take on the corporate book. Investors are tracking the quality of the corporate book like hawks. Any rise in perceived riskiness and stocks tank.
How will new projects and infrastructure get funded? Who will provide the debt needed to build new assets? Eventually, the government cannot build all the new infrastructure. Private capital is also required. The debt markets are needed to decentralise credit risk and spread it through the system, so that no one institution is left holding disproportionate credit exposures. They are also needed to break through the risk aversion, as banks are coming through the worst corporate credit cycle in their history. They are naturally risk-averse. We need to put in place new structures like alternative investment funds that can house the credit and tenure risk inherent in green-field assets. The risk taken must be transparent and the returns commensurate with the risk.
Whatever regulatory and structural changes are needed to revive the bond markets must be done. They are critical to eventually rebooting our economic growth.