Credit Spreads And Oil Price

We think the oil/energy price spike from Putin’s war may be plateauing. Here’s why.

Remember that market-based pricing by market agents is a much stronger (more reliable) indicator than loud opinions spread by messaging via TV or radio or the hysteria of social media. Those who seek attention are focused on outshouting each other. Meanwhile, market agents make real-money bets every minute and win or lose. So talk is cheap, while the real-money consensus is the strongest indicator we have.

The chart below compares the credit spreads between two measures of bonds. The credit quality is the same. The difference between the two is that one includes energy bonds, and the other doesn’t. When oil prices rise, the bonds that are issued by these energy companies get a windfall since their revenue coverage is higher and therefore the coverage of the bonds improves. The reverse is true when oil prices decline. Note that the issue becomes more complex with the use of futures and options. We will ignore those in order to simplify this commentary.

The chart below shows the history from pre-pandemic forward to the present. The widening and narrowing gap between the two measures indicates how markets judged the energy price risk.

Today, market prices of these bonds suggest that the energy price windfall is plateauing. Reason: Credit spreads in each series are about the same. Will oil prices start a strategic decline? This series says “not yet.” Is the intensity of price increases lessening? This series says “yes.” If oil plateaus, all of the energy price-related components will also start plateauing, and inflation estimates will follow. Note that I haven’t gotten to actual energy price declines. That is still ahead.

We are underweight the fossil fuel energy sector in our US Equity ETF portfolio. We are overweight the climate change-sensitive alternative energy sector.

Here’s the chart.

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