There Will be Blood: Warnings for Junk ETFs With Energy Exposure

Oil prices and exchange traded funds holding high-yield corporate bonds are not exactly moving in lockstep with each other, but there is no denying tumbling crude futures present problems for some junk-rated energy sector issuers.

Consider this: The United States Oil Fund (NYSEArca: USO) is down nearly 11% over the past month and hit a new 52-week low Wednesday. The iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK), the two largest junk bond ETFs by assets, are down an average of 2.5% over that period and also reside near 52-week lows.

Confirming that weak oil prices are problematic for the junk bond market are the aforementioned sector ETFs’ allocations. HYG allocates 14.7% of its weight to oil and gas issuers, making that the ETF’s largest sector weight. Approximately 120 of the high-yield bonds held by JNK are issued by companies engaged in the exploration, production or transportation of coal, natural gas or oil. [Oil Slicks Affect Junk Bond ETFs]

“Energy companies now account for 15 percent of U.S. high-yield bonds, up from 9.7 percent at the end of 2007,” reports Lisa Abramowicz for Bloomberg, citing Bank of America Merrill Lynch data.

With oil prices tumbling, production costs at various shale formations high and the ability of some shale operators to generate cash dubious, some fund managers see a day of reckoning coming for high-yield exploration and production issuers.

“Much of the U.S. E&P industry is unsustainable,” said Peritus Asset Management Chief Investment Officer Tim Gramatovich in an interview with ETF Trends. “It’s (shale exploration) is like getting blood from a turnip. These are horrible reservoirs with viscous decline curves, meaning wells deplete by 90% in two years. There’s a lot of E&P high-yield paper floating around and many of these issuers will fail.”

California-based Peritu is the sub-advisor for the AdvisorShares Peritus High Yield ETF (NYSEArca: HYLD). Pertius, which manages over $1 billion in client assets, including about $663 million at the actively managed HYLD, does not own debt issued by domestic shale producers. [Positive Growth Pace for Active ETFs]

“These companies are highly leveraged with no free cash flow,” notes Gramatovich. “I can’t give you a loan for that type of business. A lot of these companies weren’t sustainable at higher oil prices. The real problems haven’t started yet because a lot of these companies are hedged a year out, but there is huge default risk coming, whether oil prices come back or not.”

Now, declining oil prices threaten producers’ ability to profitably tap various shale formations, particularly those in Texas. With West Texas Intermediate futures, the U.S. benchmark contract, nearing $80 per barrel, analysts and industry observers are now talking about breakeven points for U.S. E&P firms, though some of these companies have dangerously vowed to keep pumping even if oil prices keep falling. Lacking the ability to generate cash flow, those companies are likely to encounter difficulty in locating lenders willing to extend credit.

“I looked at 50 E&P companies that could not generate free cash flow at higher oil prices,” said Gramatovich.

Then there is the matter of increased leverage. At the end of the second quarter, U.S. shale producers had a total of $190.2 billion in debt, up from less than $150 billion at the end of 2011, according to Bloomberg data.