Best Debt Bet You Can't Make

Energy might be a winner. Too bad it could crush you.

Kyle Bass thinks it’s a wonderful time to invest in energy companies. He made half a billion dollars betting against subprime-mortgage securities in 2007, so it’s worth listening to his ideas.

His latest one is that the beaten-down energy sector is primed for a rebound. There’s only one catch: It’s incredibly difficult for nonenergy specialists to make this trade. Even Bass himself acknowledges that there just aren’t enough financial instruments available to target the most promising companies easily and quickly, a point he made in a recent “Wall Street Week” interview. The best the average investor can do, Bass said, may be to buy shares of a crude oil exchange-traded fund and hang onto it for about two years.

But that’s a blunt instrument when a scalpel and nimble moves are required. Before the financial crisis, collateralized debt obligations and single-name credit-default swaps allowed traders to quickly make the bets they wanted to take advantage of a fundamentally flawed housing market. When it comes to the energy sector, the opportunity is different and much more complex. The right tools just don’t exist for most investors, exposing them to dangerous risks if they try to take a shortcut.

Consider the exchange-traded fund suggestion. Correlations between these funds and the oil markets they track can break down. When oil prices rebounded by 78 percent in 2009, the $3.1 billion United States Oil ETF gained only 19 percent. The fund has returned about 50 percentage points less than the oil benchmark in the past seven years, losing 67 percent in the period, according to data compiled by Bloomberg.

Falling Behind

The biggest oil ETF has trailed behind oil benchmarks.

Source: Bloomberg

"No average investor should mess with this,” said Eric Balchunas, an ETF analyst with Bloomberg Intelligence. While the funds may result in some gains amid an oil recovery, investors need to have a deep understanding of futures markets to use these energy ETFs effectively.

It’s understandable that a growing number of fund managers see opportunity in the energy industry. High-yield debt of these companies just suffered its worst six-month stretch on record, with a 27 percent decline in the period ended Dec. 31, according to Bank of America Merrill Lynch index data. Yields on this debt have surged to 16 percent from 5.7 percent in 2014.

The last comparably big rout in this debt was in 2008. After losing 26 percent in the second half of that year, it gained almost 30 percent in the following six months.

Oil Blues

Crude prices have tumbled as global growth slows.

Source: Bloomberg

Oil prices have been hit by weaker demand from China and greater supply from the U.S. and Middle East. Crude prices have plunged to $36 a barrel from a high of about $107 in 2014.

While the latest debt selloff may yield another boom in energy values, many companies will go out of business along the way. If investors buy bonds of the wrong company, or purchase debt that’s too low in a company’s capital structure, they may get wiped out completely, even if oil prices recover eventually.

Bass predicts that the global oil glut will suddenly turn into a shortage, a process that he predicts will take about two years.

“The world’s not ready for a deficit,” he said. “The margin of safety for the globe is the smallest its been in energy.”

Bass may be right, and oil companies may end up being a billion-dollar bet for some skilled energy analysts and traders within the next 24 months. But there will also be some big losers who have the right idea but wrong execution.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at

    To contact the editor responsible for this story:
    Daniel Niemi at

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