Wed, Feb 24, 2016|Justin Brill

A critical 'test' for the junk-bond market...

A critical 'test' for the junk-bond market... The shale-oil 'architect' agrees with Porter... What Saudi Arabia is really thinking... A big bet on 'oil mud'... Another big decline could be starting now...

Regular Digest readers know the bond market is one of the "lions" Porter has been warning about for months.

As he noted last week, the collapse in high-yield – or "junk" – bonds was his No. 1 warning sign that a bear market was coming.

Now it appears the junk-bond market is headed for its first serious test since the turmoil began...

The Wall Street Journal reports that toy retailer Toys "R" Us is about to become one of the first companies to try to refinance a huge chunk of high-yield debt since yields began soaring last year.

Toys "R" Us – currently rated in "deep" junk territory – is looking to refinance three bonds worth $1.6 billion. This debt doesn't come due until 2017 and 2018. But the company is worried the credit markets could worsen from here, and is in a hurry to complete the deals by April.

For perspective, average junk-bond yields have jumped from less than 6% last year to more than 9% today. The "junkiest" junk bond yields – those rated CCC or below, like Toys "R" Us – have soared from less than 8% on average to more than 20% today. Despite much higher yields, just $11.8 billion of junk bonds has been issued so far this year, versus more than $45 billion over the same period last year.

These three Toys "R" Us bonds are currently trading at distressed prices ranging from $0.73 to $0.83 on the dollar... meaning the company may have to offer substantially higher yields to entice buyers.

If Toys "R" Us struggles to refinance this debt, it could put the company's future in jeopardy. But more important, it could be a sign of even bigger problems for the high-yield market in general...

According to ratings agency Standard & Poor's, U.S. companies have a total of $1.3 trillion in high-yield debt maturing between now and 2020... including $92.3 billion coming due this year... $160.9 billion in 2017... and an incredible $272.5 billion in 2018.

Switching gears to another of Porter's "lions," regular readers know we've also been covering the ongoing turmoil in the oil industry.

Today, we're checking in on CERAWeek, the high-profile annual energy conference put on by Pulitzer Prize-winning author and energy economist Daniel Yergin.

The conference – named after Yergin's company, Cambridge Energy Research Associates ("CERA") – is held in Houston each year, and attracts top energy executives, government officials, and investors from around the world. You can think of it as the World Economic Forum for the energy industry.

One of the most notable talks from this year's conference came from Mark Papa, former CEO of shale driller EOG Resources (EOG).

Papa helped create the entire shale-oil industry... It was his company that pioneered the use of hydraulic fracturing and horizontal drilling – originally designed to extract natural gas – to produce oil instead. No one in the world knows more about the shale-oil industry.

Papa told attendees that many shale companies are "grievously wounded," and predicted the industry would be obliterated in the months to come. "It's going to be really, really ugly to get through this valley," he said.

He also warned it could take another 16 to 24 months before falling production finally causes prices to rebound.

Despite the near-term problems, he believes the shale boom will be incredibly positive for the U.S. economy...

The future is pretty bright for U.S. production, and I could envision the U.S. could be producing 13 to 14 million barrels a day of crude oil [by 2022.] The future could be a lot brighter than people think.

Hmm... where have we heard that before?

One of the last people you might expect to find at a conference full of shale-oil executives – Saudi Arabian oil minister Ali al-Naimi – also spoke. And you might be surprised by what he said...

Regarding the tentative agreement between OPEC producers and Russia to freeze production, al-Naimi said there's no chance it would lead to cuts in production. "That is not going to happen," he said, noting Saudi Arabia doesn't trust other countries to "share the sacrifice."

Instead, he said it will keep production where it is now and let low prices put higher-cost producers out of business...

It may sound harsh, and unfortunately it is, but it is the most efficient way to rebalance markets... Cutting low-cost production to subsidize higher cost supplies only delays an inevitable reckoning.

He also denied that Saudi Arabia was trying to wage a war on U.S. shale producers or attempting to increase its market share. Instead, he said it was simply responding to market pressures...

We are doing what every other industry representative in this room is doing... Efficient markets will determine where on the cost curve the marginal barrel resides.

Al-Naimi showed his sense of humor, too...

According to Bloomberg News, the 81-year-old told the audience how he started his career as an "office boy" in 1947 for Saudi Arabia's state-owned oil company, Saudi Aramco. He noted that he has seen plenty of booms and busts over that time. "I've even survived peak oil," he joked. "I think I have a t-shirt somewhere with that on it."

Finally, another energy executive was notable, but for a different reason...

Steve Williams, CEO of Suncor (SU) – Canada's biggest oil sands producer – said his company will continue to increase its oil production even if prices continue to fall. He also claimed his company would "be one of the last guys standing" when the crisis finally ends, noting, "With the kind of assets we have, it's a wall of cash that just keeps coming at you."

According to the Wall Street Journal, Williams noted his company's operating costs are slightly lower than $20 per barrel, and said prices would have to fall – and stay – below that level for a while before the company would consider cutting production.

And apparently, he doesn't expect that to happen... The company just completed a buyout of its smaller rival – Canadian Oil Sands Limited – and is still planning to open a brand-new $15 billion mine next year.

We expect Williams will regret that decision...

Porter has explained the problems with the "oil mud" industry many times, so we won't rehash them all here.

In short, oil sands companies don't actually extract crude oil... they extract bitumen, a viscous mix of hydrocarbons that was traditionally used for roofing and road surfacing.

Bitumen requires more energy (and therefore, more expense) to extract, refine, and transport than a comparable barrel of oil... particularly the light, "sweet" crude produced from shale here in the U.S.

When oil prices were higher (and folks thought we were running out of oil), turning Canada's massive reserves of bitumen into oil made sense. Now that U.S. producers have unlocked huge new supplies of light, sweet oil and prices have crashed, that's no longer true.

Williams claims Suncor's costs are lower than $20 per barrel, but there's no denying low oil prices are hurting the company... It reported a net loss of more than $2 billion last quarter, citing "impairment charges... as a result of declining crude oil prices."

If oil prices remain low for some time – as we expect they will – there will likely be many more losses to come.

As Porter noted in a private e-mail this morning, "It's a really bad business mining road tar."

We'll end today's Digest with a warning from technical analyst Tom DeMark...

If you're not familiar, DeMark uses a proprietary momentum indicator to time moves in the market.

According to DeMark, the benchmark S&P 500 Index triggered a bearish "sell" signal as of yesterday's close. He now expects the index to fall to at least 1,786 in the coming days... a level not seen since February 2014. That would represent a decline of more than 7% from today's close... and push stocks into official bear market territory.

As always, we'd never recommend making investment decisions based on technical analysis alone... but DeMark has advised top hedge funds like George Soros' Soros Fund Management and Leon Cooperman's Omega Advisors, and he is highly respected on Wall Street.

His warning is simply one more reason to be cautious today.

If you still haven't taken a few simple steps to prepare for a bigger decline in stocks, click here to learn more about our Bear Market Survival Program now.

One final note... Porter wanted me to pass along a surprising offer that his start-up, men's luxury-razor business is offering for a limited time. For the next 30 days, you can get a $299 OneBlade men's shaving razor FOR FREE. Click here for details.

New 52-week highs (as of 2/23/16): Franco-Nevada (FNV) and short position in SPDR S&P Oil & Gas Exploration & Production Fund (XOP).

In the mailbag, a subscriber has a question about using options to short a stock. Send your questions and comments to feedback@stansberryresearch.com. As always, we can't provide individual investment advice, but we read them all.

"Dear Porter and associates, I have fully enjoyed reading and learning about how to better protect your portfolio in a bear market. Even though I am an alliance member, I am still very much a novice investor. I appreciate how hard you and your analysts have worked to continue to add value to every subscription offered.

"After learning more about the strategy of selling puts as a safer way to establish a long position on a stock, I'm wondering if selling uncovered calls is a safer way to establish a short position on a stock. I realize that this can be dangerous because of the need to cover a short position if a stock price goes up, but if you stick to your stops, it seems like you gain the advantage of time by selling the option. It would be much appreciated if you could get back to me about this. I've thought a lot about it, but am too apprehensive to actually try it out without any additional input. Thanks for any response." – Paid-up subscriber Bret R.

Brill comment: Yes, selling naked calls is a way to generate income on stocks you expect to fail. And yes, experienced traders can use this strategy to "lever up" on a short position.

We don't recommend it, though. Shorting is hard enough. It's awfully hard to consistently get the timing right.

If you'd like to learn more about short-selling – as well as all our strategies for protecting your savings and profiting as stocks fall – consider signing up for our Bear Market Survival Program. You can get all the details here.

Regards,

Justin Brill
Baltimore, Maryland
February 24, 2016

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