Falling oil prices and what it means for credit markets

Oil prices have been gathering headlines in the last few weeks. After falling below the $60 per barrel mark, the West Texas Intermediate price (WTI) bounced back strongly as a result of fresh sanctions announced against the two Russian giants, Lukoil and Rosneft. Oil prices are important for a variety of reasons: they are a driver of CPI and PPI inflation, may give clues about aggregate demand, and have a geopolitical component attached. From a high yield investor’s point of view, higher oil prices may put pressure on margins of certain industrial issuers or even cause a default cycle in those geographies where there is a large concentration of Exploration and Production (E&P) companies.

As the graph below shows, oil prices have been trending downwards for some time and most forecasters expect prices to be flat or to continue falling into 2026. The global economy is forecast to grow at a modest 3% this year, but manufacturing continues to be weaker than services, which means oil demand remains subdued. As an example, the Energy Information Administration (EIA) projects that global supply will outpace demand at a record pace. Weak industrial activity in Europe since Russia’s invasion of Ukraine in 2022 has weighed on demand, compounded by China’s slow post-Covid recovery. In the US, tariffs have raised concerns about a softer economic outlook, particularly in the manufacturing sector, and with the typical seasonal drop in demand from the Northern Hemisphere through winter, prices may decline further.  

On the supply side, output is increasing as OPEC has relaxed output curbs and several producers ramp up activity.  Most notably, the United States under President Trump’s “drill baby drill” agenda, alongside Brazil, Canada, and Guyana, have added to the excess supply. The EIA expects global crude oil and liquid fuel production to rise by roughly 2.7 million barrels per day (bpd) in 2025 and a further 1.3 million bpd in 2026, compared with demand growth of only 1.1 million bpd in both years. As a result, global petroleum inventories are set to build by about 2.6 million bpd in Q4 2025 and 1.9 million bpd in 2026. Morgan Stanley and Goldman Sachs both forecast Brent oil in the $55-$60 context for 2026.

Sustained price weakness would place pressure on margins for oil producers. Below a certain “breakeven” threshold, extraction stops being commercially viable, prompting companies to delay production until pricing recovers. Breakeven levels vary widely across producers and geographies, with lower thresholds for large integrated majors compared with smaller, less diversified operators. Shell, for instance, can sustain dividend payouts as long as oil remains above $40 per barrel. Ithaca Energy, on the other hand, a BB-rated North Sea producer, targets project breakevens of $30–$50 per barrel, suggesting reduced investment if prices fall below $50. In the US, breakevens differ substantially by region - the best spots of the West Texas Permian can boast breakevens at or below $40 WTI, whereas higher-cost plays such as offshore deepwater Gulf of Mexico require over $60 WTI to remain economical.

In European High Yield credit, direct oil exposure remains limited, with energy-related bonds forming only ~2% of the Euro HY Index. These include both producers and service providers, the latter offering equipment-rental, logistics, and maintenance solutions. While upstream earnings are highly sensitive to price swings, service companies generally benefit from steadier demand and longer-term contracts, which help absorb volatility. In contrast, the USD High Yield market has greater exposure at ~11% of the index. This mainly reflects the US’s role as the largest oil producer in the world, and is potentially a reflection of lower ESG-based capital constraints in the USD market than in Europe.

Lower oil prices would theoretically bring relief to energy-intensive industries. European chemicals producers, for example, could gain some respite after years of competitive strain from high energy costs, as we discussed in a recent blog: Is there value in the troubled European chemicals sector?. However, given oil’s weakness is partly a reflection of subdued industrial activity, the net benefit is likely to be limited, as cost-savings will be offset by top line declines.

Given the high degree of uncertainty and the potential for new geopolitical or policy shocks, such as further tariffs or supply shifts, we prefer to steer clear of pure oil producers whose futures are highly dependent on commodity prices, that are out of their control. We see the E&P sector more as an equity rather than fixed income trade, as equity holders are the ones who capture all of the potentially large upside of oil prices increasing dramatically for whatever reason, while bondholders are quite exposed on the downside given many issuers simply cannot make money if oil prices fall beyond a certain threshold. Instead, from a fixed income standpoint, we see more value further down the value chain in spots such as midstream pipelines and select oil services companies that maintain business models that are more insulated from short-term commodity price volatility.

We are not in the business of forecasting oil prices, but we can easily see how default rates may increase in this sector if prices stay low for too long. The last time this happened was in the US in 2014-2016. This was a tough period for high yield investors, but due to the generalised contagion, also provided an opportunity to take exposure to names that had little to do with oil prices, but were unfairly punished. Time will tell whether we see another of these episodes next year.