What Drives Credit Spreads of Oil Companies? Evidence from the Upstream, Integrated and Downstream Industries.

• Date: 01 September 2023
• Author: Ma, Yihong

1. INTRODUCTION

   Post the 1990s, the world has seen a further increase in debt-issuance activities by the corporate sector in financial markets not only due to the diversity of the available financial instruments such as corporate bonds but also to the wide range of funding instruments made available to fund credit growth. This has enabled firms to diversify their capital-raising activities away from equity financing by allowing greater access to debt funding domestically and off-shore. Equity capital is raised either through offering share placements to offshore investors or through initial public offerings (IPOs). Since energy companies' capital expenditures tend to be much larger than comparable companies operating in non-oil-related industries, then so does the required funding needed to back them. Therefore, firms have shifted from more conservative intermediate bank funding to relying more on directly accessing capital from both domestic and offshore debt markets.

   Despite the development of alternative energy sources over the past few decades, the oil industry remains one of the dominant energy industries in the world. Considerable empirical research on the oil industry highlights that the volatility of prices has not only impacted the production and value chains but also other sectors creating instability in the world economy. For the financial markets (particularly the stocks, bonds and derivatives markets) and analysts, the behavior of the oil industry is an important indicator of the future health of the world economy and stability in oil-related industries. Credit default swaps (CDS) trading in the oil-related value chain are considered an important measure of credit risk and a future economic indicator of the industry, both upstream and downstream.

   This rapid increase in corporate debt issuance has seen oil-industry companies raise vast amounts of debt through multibillion-dollar credit facilities. Due to the Covid-19 epidemic, many of the world's largest oil companies have tapped global corporate debt markets to secure capital to meet future capital requirements. Oil companies such as Royal Dutch Shell, BP, Equinor, Total and Exxon Mobil have tapped into an excess of US$32 billion in new debt issuance in order to manage the financial fallout of the coronavirus and to continue meeting dividend payout polices for shareholders.

   Appendix 1 (1) provides a summary of the enormity of debt profiles of firms engaged in the oil industry. Accordingly, the amount of senior unsecured debt, the focus of this paper, held jointly by the firms in the oil industry by 2020 accounts for approximately US$750 billion or 84% of total debt funding and 61% of total market capitalization. Debt figures include only securities traded in capital markets and omit total bank loans outstanding. Tradable debt in the data set equates to approximately US$900 billion and is backed by US$1.4 trillion in equity. If we include loans from banks, total outstanding debt is closer to total market capitalization. Interestingly, the excessive debt to equity ratios are more akin to ratios observed within the highly-regulated banking sector. For example, companies such as Occidental, Apache, Antero and Energy Transfer have debt to equity ratios of 3-4:1. Many others operating across the supply chain including Marathon, Murphy, and Plains All American also have excessively high levels of debt.

   The research by Fuller et al. (2018), using a sample of U.S. listed firms from 2002 to 2016, examined the impact of CDS spreads on finance and trade credit policies. They found that CDS trading does affect firms' financing policies. Specifically, the authors found that firms' with CDS instruments trading on their debt commitments tend to increase their net equity capital in favor of debt capital. Reducing debt capital issuance because of CDS trading will result in an increase in a firm's overall cost of capital given equity is more expensive than debt capital. In other words, firms with CDS trading on their debt increase net equity capital and reduce their debt capital financing. The authors also found that once the market establishes CDS trading on a firms' debt instruments, capital structure policies of those firms' are affected although this impact is non-linear. Considering the debt funding programs of most firms in this research (see Appendix 1) are significantly large, any given shock in the market may also affect firms' capital structure decisions and therefore overall firm value.

   The oil industry uses some specific terms to identify oil- and gas-related firms in the supply chain such as upstream, downstream and integrated. The upstream firms cover discovering oil and gas, feasibility studies, operation of oil and gas rigs, machinery and equipment supplies, and extraction chemical supplies (i.e. Conoco Phillips, Woodside Petroleum). The downstream firms cover refineries, marketing and distribution channels moving the refined products to the end uses (i.e. Energy Transfer LP, Enbridge Inc). Some firms are identified as integrated because they combine two or more activities within the above two segments (i.e. Royal Dutch Shell, Exon Mobile). Generally, it is plausible that upstream firms are more responsive to crude-oil price changes, global economic (such as exchange rate) and geopolitical environments (such as supply controls due to OPEC decisions and embargoes) because most use derivative contracts to respond quickly to any exogenous shock.

   Given the dominance of the oil- and gas-related industries in the world economy, exogenous or endogenous shocks may not only affect the industry value chain but also other industries and the financial system including the derivative markets because any changes in oil prices may affect oil-related derivatives in the upstream industry. Endogenous shocks include, for example, political embargoes, supply controls such as imposed by OPEC, and demand-driven factors. The exogenous shocks may include monetary policy changes, exchange rate fluctuations and financial crises.

   The objectives of this research are to fill the gap in the literature by focusing on the dynamic relationship between the CDS spreads of oil-related firms, the US dollar exchange rates, and crude oil prices, and especially whether the dynamic relationships change during crises and among different firms in the oil industry. A similar study using oil shocks by Stock and Watson (2016) showed how to extend methods to identify demand-driven shocks in structural vector autoregression to dynamic factor models. This research empirically tests whether exogenous shocks at the upstream level have major influence on the financial markets relative to the downstream level where shocks are mainly demand-driven. We formed our research question based on the commonly believed hypothesis that it is the upstream oil industry that has a greater impact on oil-related derivative markets than the downstream industry. Accordingly, we first construct a panel VAR model to investigate the dynamic relationship between the three variables--CDS spreads, USD index, and oil prices. Then we conduct impulse response analyses during different crisis periods, namely, the 2007 financial crisis (FC), the 2014-16 oil price shock (OPS) and the Covid-19 pandemic on different firms in the oil-industry value chain such as upstream, vertically integrated and downstream firms.

   The remaining parts are organized as follows. Section 2 provides the background literature related to this research. Section 3 presents data collection processes and variables used. Section 4 describes the methodology. Section 5 reports the empirical results. We conduct a set of robustness tests in Section 6 and Section 7 concludes.

2. LITERATURE REVIEW

   An approximate measure to a no-arbitrage opportunity suggests that, ceteris paribus, the CDS spread should be identical to the credit spread between the yield to maturity on a risky par bond and the benchmark risk-free rate (Duffie, 1999, Hull and White, 2000). Generally, a firm wishing to raise debt is charged a margin on their borrowings above the respective benchmark interest rate such as the London Interbank Offered Rate (Libor). The margin itself is based on variables such as the borrowing firm's credit rating, size of the issue and maturity, and general market and macroeconomic conditions. This study uses CDS spreads as a proxy representing the credit spread on firms' tradable debt securities. A considerable amount of literature has been published on the rationale of using CDS spreads as a substitute for corporate bond spreads. Chen et al. (2010) described a CDS spread as being a purer quantification of credit risk than the equivalent bond spread due to the swap nature of a CDS. Longstaff et al. (2005) analyzed price differences of CDS spreads and bond spreads using weekly data and found that price variations are primarily due to individual corporate bond illiquidity. Likewise, Das et al. (2009) used CDS spreads as a proxy to analyze models for measuring corporate credit risk. Blanco et al. (2005) found that the equilibrium price of CDS spreads and bond spreads persists on average over time for a majority of firms; however, significant price variations between the two spreads are evident in the short run and are due to either contract specifications or that the bond spread underprices the true credit risk of the issuing firm. Similar findings highlighting the efficacy of using CDS spreads over bond spreads can be found in Delatte et al. (2012), Houweling and Vorst (2005), Hull et al. (2004), Zhu (2006).

   Seminal work by Merton (1974) paved the way for a stream of empirical and theoretical work in proposing a structural firm-value approach to pricing corporate bonds. This model derives a closed form for the credit spread on a risky zero bond using asset growth, asset volatility and leverage as the key determinants for the probability of default. Numerous...