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    Gas Explosion: What Caused the 2021 UK Energy Crisis?

    One of the most interesting tidbits of recent news to impact the markets has been the squeeze of natural gas prices on the wholesale markets in the United Kingdom. While comparisons can be drawn to historical events to rank its severity, the chart below does a better job speaking for itself: It may be tempting to discount natural gas as yet another meme stock or as a casualty of supply shocks resulting from the COVID-19 pandemic, the truth of the meteoric rise is significantly more complex. Regardless of opinion, unless you were an ill-positioned short fund, Gamestop presented for most no more than a news curio, while the impact of the natural gas surge has already had significant negative impacts not only on the energy and foodstuffs industries, but on the end consumer and the broader economy.

    To limit consumer exposure to natural gas market price instability in the United Kingdom, Ofgem, the Office of Gas and Energy Markets, has capped prices for both fixed-rate (since 2017) and variable rate (since 2019) energy plans, adjusting prices biannually. This cap means that during price squeezes, insufficiently hedged energy suppliers bear the brunt of wholesale price increases and must provide gas to end customers at a loss. Despite increasing the cap over 10% on October 1st for end customers, this has done little to alleviate the suffering of United Kingdom natural gas suppliers. In September alone, nine suppliers representing nearly two million domestic customers in the United Kingdom became insolvent, requiring Ofgem to arrange service continuation strategies to reduce consumer impact.

    Worse yet, most predict the situation to increase in severity as winter arrives, given the intuitive correlation of energy usage and ambient temperatures.

    Hello everyone! This will be the first post in a blog series focusing on applications of quantitative credit data to broader market trends. Having recently joined Moody’s Analytics, this blog will be structured akin to the journey of a learner – along the way, I want to share insights as I discover them, and how to best utilize a world of rich consumer, economic, and corporate credit data to paint a fuller picture of what’s going on. As someone fascinated by the mechanics of the options markets, meme stocks, and stock market bubbles, it seemed fitting to begin this journey there.

    Retail trading is a front-and-center issue in many market participants’ minds, having grown dramatically in recent years due to the emergence of low-or-zero transaction fee retail brokerages like Robinhood. While initially the phenomenon was confined to small, highly concentrated niches, it is indisputable that retail traders have become a substantial force. This influence can be felt market-wide, as potentially one of the drivers of the equity options markets boom post-COVID. However, nowhere can it be felt more strongly than in the new 2021 asset class, “meme stocks”.

    Many still view the trend (and its major epicenters, Gamestop Corporation and AMC Entertainment Holdings Inc.) as temporary price dislocations in the equity markets, driven partly by dedicated online communities like WallStreetBets and by the hedging of equity options market makers. Conversely, both meme favorites have demonstrated a stubborn resilience, with equity prices for both remaining markedly elevated since the first signs of the squeeze. This begs the question – what, if anything, materially changed for both companies?

    A classic short squeeze (as many viewed the initial January 2021 squeeze) does not tend to drag on for months after an initial rapid price increase. Comparing recent price action to the 2008 Porsche-Volkswagen short squeeze or the more recent March 2020 squeeze of Blue Apron, usual short squeeze, we see a stark difference in duration. While in all cases we observe substantial declines in short interest post-squeeze, the Blue Apron and Volkswagen culminating events were brief (lasting days) rather than a protracted battle lasting multiple months. It is hard to explain the current situation as a simple short squeeze.

    Looking at the credit data, we can see a different perspective. For both AMC and Gamestop, the presence of a price-insensitive, loyal shareholder base fundamentally changed the solvency and credit outlook of both firms by allowing them to draw capital from increased equity pricing and sustained interest. This capital injection led to creation of fundamental value, improving debt structure, creditworthiness, and reducing default risk dramatically. While many discount these squeezes as one-off events, I argue that the advent of retail trading and social media-driven investing creates a novel factor in understanding future credit risk, especially in the context of heavily shorted and indebted companies (which tend to be retail favorites). This can be used by both short sellers and yield-seeking investors to better model risk and find asymmetric return opportunities.

    Equity and Defaults

    It is well-known that the market capitalization of a firm must reflect implicitly the likelihood that a firm will default in the future. During a default, shareholder equity becomes worthless (although in some cases after reorganization shareholders can negotiate some positive value in the recapitalization). In 1974, Robert Merton provided the key realization that due to limited liability, if a firm is underwater on debt, shareholders can choose to simply liquidate the firm rather than pay back debt. From that perspective, the equity value of a firm can be viewed as a call option on the firm’s assets, with the option for the shareholders to liquidate if debt exceeds asset value (the option expires out-of-the-money) or not liquidate (the option expires in-the-money and is exercised).

    This core thesis underpins how to quantitatively model defaults, best summarized as an Expected Default Frequency (EDF). Prior research using the EDF9 Model (derived from the Merton model) has supported the tacit link between equity valuation and default frequency, with significant excess returns noted for firms with lower probabilities of default than riskier firms.

    From this, we can observe that equity markets, despite potentially uninformed or faddish trading, over the medium-term should reflect credit market information. All things otherwise held similar, the greater liquidity and smaller notional size involved in equity markets implies greater investor accessibility, and investors can often express their credit outlooks more rapidly and easily via equity versus credit. An extreme example of this should occur for companies near to a credit event – as a company approaches default or bankruptcy, it should see precipitous declines in stock price, with the converse (e.g. a rescue package or cancellation of debt) also holding true.

    Interestingly, the relationship between EDF and equity returns tends to be smile-shaped: poor equity performers have higher credit risk, but firms with highly positive equity performance also exhibit heightened default risk, likely correlating with increased use of debt leverage.

    However, this relationship is not unidirectional, as we can see strongly for both AMC and Gamestop. For both meme stocks, the rapid increase in equity price and interest allowed them to raise substantial capital via offerings, materially impacting their ability to service debt and avoid insolvency. Although pre-squeeze most investors discounted both firms as eventual casualties of the macro changes driven by the COVID-19 pandemic, using EDF data, we can see both companies underwent dramatic shifts in credit risk.

     

    Per our EDF model, the 1-year forward chance of default for Gamestop Corporation peaked around May 2020 at nearly 20% (nearly 1200% higher than in 2018). While since then the default point (the time-weighted value of Gamestop’s outstanding debts) remained largely constant, as asset value increased during the squeeze its market leverage (asset value versus default point) markedly decreased while asset volatility (the volatility of the dollar value of Gamestop’s assets) increased.