Credit Risk and mild explosivity of Credit Default Swaps in the Corporate Energy Sector

Abstract

This paper provides a new dimension to the determinants of credit risk in the energy sector over the last two decades. We measure credit risk in energy corporations using CDS spreads and CDS sectorial energy indexes and assess whether credit risk in energy companies exhibited significant departures from random walk behavior during the last two decades. Using the multiple bubble methodology proposed by Phillips Shi and Yu (2015) we detect two predominant mildly explosive periods in CDS spreads: a first episode during the Global Financial Crisis and another important mildly explosive period around and after the recent 2014 crude oil price collapse. We also find a less statistically significant rise during 2010-2011 that is similar in crude oil prices. We associate the salient features observed in CDS spreads with the corresponding fundamental forces. In particular, we look at the time series behavior of crude oil prices, and other financial variables such as the US 5 and 10 year real yield and different corporate leverage measures. Results show that the 2014 and 2015-2016 episodes of mild explosivity reported for CDS spreads in energy corporates and CDS energy sector indexes can be tied to statistically significant decreases in crude oil prices as well as to abrupt rises in debt levels, debt-equity and debt-EBITDA ratios following the effects of Taper Tantrum in 2013. The latter lead to departures from martingale behavior in real bond yield measures and crude oil prices with a subsequent increase in credit risk. The paper therefore brings a new dimension to the recent crude oil price literature.

This paper provides a new dimension to the determinants of credit risk in the energy sector over the last two decades. We measure credit risk in energy corporations using CDS spreads and CDS sectorial energy indexes and assess whether credit risk in energy companies exhibited significant departures from random walk behavior during the last two decades. Using the multiple bubble methodology proposed by Phillips Shi and Yu (2015) we detect two predominant mildly explosive periods in CDS spreads: a first episode during the Global Financial Crisis and another important mildly explosive period around and after the recent 2014 crude oil price collapse. We also find a less statistically significant rise during 2010-2011 that is similar in crude oil prices. We associate the salient features observed in CDS spreads with the corresponding fundamental forces. In particular, we look at the time series behavior of crude oil prices, and other financial variables such as the US 5 and 10 year real yield and different corporate leverage measures. Results show that the 2014 and 2015-2016 episodes of mild explosivity reported for CDS spreads in energy corporates and CDS energy sector indexes can be tied to statistically significant decreases in crude oil prices as well as to abrupt rises in debt levels, debt-equity and debt-EBITDA ratios following the effects of Taper Tantrum in 2013. The latter lead to departures from martingale behavior in real bond yield measures and crude oil prices with a subsequent increase in credit risk. The paper therefore brings a new dimension to the recent crude oil price literature.