A persistent theme in these pages is the extent to which the mammoth spread compression (i.e. rally) we’ve seen in HY over the past 13 months isn’t justified by crude prices or by the fundamentals underpinning the oil market.

To see this, simply have a look at the following chart we’ve highlighted before:

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Put simply: the last time cash and synthetic spreads were as tight as they were prior to oil’s plunge earlier this month, oil was hovering around $90/bbl.

Not only are we nowhere close to $90/bbl, but not even the most optimistic of forecasts sees us getting there anytime soon.

Now the counterargument is that US operators have learned their lesson and are now more efficient  – you know, lower breakevens and all. Which is fine. If the US energy complex is now leaner and meaner and thus prepared to truly compete, then great. Good for those companies. But it sure doesn’t inspire much confidence in that narrative when the first thing these companies do once oil rises above ~$50 is go out and tap equity markets for nearly $7 billion in capital – which is exactly what happened in January.

In any event, in light of everything said above, consider the following from UBS who is out with a great note detailing the level at which, to put it colloquially, sh*t hits the fan for US energy and in turn, for HY as a whole.

Via UBS

At what oil price level should the sensitivity of US high yield energy spreads escalate? We believe the low $40s is the key threshold. Why? Cash flow is king, and we find a stronger relation between HY energy spreads and the differential between breakeven oil prices for US shale and 12mo WTI (Figure 8). According to our colleagues the average breakeven oil price has fallen from $65 in early 2014 to $56 in early 2015 and $43 by mid-20166. In recent years, when 12mo forward oil prices have fallen below breakeven levels, HY energy spreads have surged – suggesting distressed concerns quickly get priced into market spreads.

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How much widening could materialize in US and EU HY if oil prices head towards $40? First, we believe longer run (12mo) oil prices would matter more as many HY energy issuers have been able to extend liquidity profiles out to 2018 amidst more flexible capital markets and hedging activity. But while only 6% of HY energy firms are characterized as having weak liquidity, 41% of the universe has adequate, but not good or great liquidity. In part this reflects a debt maturity profile which is higher this year than last, specifically for 2019 maturities (Figure 9).

Second, we estimate spreads using the historical association of oil prices to spreads under multiple assumptions: we use the empirical relationship between oil and HY energy spreads since 2013 to estimate the change in spreads (lower bound, assuming no convergence to trend), and then we also assume 50% convergence to trend (upper bound, Figure 10). Further, we note triple C and single B energy issuers have also rallied aggressively from the lows, with spreads fully normalizing relative to index triple C and single Bs. In our view, this pricing suggests ample room for valuations to re-price lower should oil approach the $40 level.

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Third, for HY ex-energy spreads we forecast using a similar approach as that outlined for HY energy spreads.

Overall, this approach translates into 180-380bps and 60-110bp of widening in HY energy and ex-energy spreads, respectively, if 12mo oil futures approach $40. This would translate into overall HY spreads rising 75bps-150bps to 485-560bps. Finally, we would note that HY market spreads already look expensive versus our model (426bp market vs 534bp model, or 1 standard deviation).