Another One Bites The Dust!

05/31/2016 01:05 AM

A Case Study of Pacific Exploration & Production Corporation Using KRIS Default Probabilities
May 31, 2016

The objective of this write-up is to showcase how the Kamakura Risk Information Services (“KRIS”) default probabilities subscription service assists users to manage exposure ingress and egress based on Kamakura Default Probabilities (“KDP”) movements.

On April 27, 2016, Pacific Exploration & Production Corporation (NASDAQ: PRE) (“Pacific”) filed for bankruptcy protection. Pacific Exploration & Production Corp and its units filed for protection from creditors in Canada after failing to cope with a prolonged slump in oil prices. The company missed an interest payment due on March 28, making it the first Toronto-listed oil and gas company in the past one year to delay a payment. Pacific Exploration reached a deal with debtholders, including Catalyst Capital Group Inc, last week to convert almost all of its debt to equity.

This document highlights how KRIS and related risk measures would have allowed investors to exit from a position in Pacific well before the default event of April 27.

The default probabilities produced by the KRIS service include both the best practice reduced form default probabilities and the older and less accurate Merton model default probabilities. In this note, we use the KRIS version 6.0 reduced form default probabilities, the newest and most accurate model in the KRIS default models framework.

The chart below shows the history of the 1-year (in blue) and 10-year (in red) default probabilities for Pacific:

In Kamakura Corporation’s popular troubled company index, a firm is considered “troubled” if its default probability exceeds one percent. The box on the left hand side of the graph above shows that the 1-year default probability of Pacific first exceeded 1.00% in September 2014, 1 years and 7 months before Pacific defaulted. For a fixed income investor, this is tremendous early warning, and highlights exit options well before a default event. One also immediately notices that the one-year KDPs of Pacific rose to 15% in March 2015 and though volatile, never came back to below 6%, whilst the 10-year KDPs steadily showed an uptick hovering around 6%.

Another important metric in KRIS is the cumulative default probability for the issuer. On December 1, 2014, the cumulative 10-year default probability for Pacific was a very high 11.77%. This metric was a warning signal provided by KRIS a full eighteen months before default.

A third analytic in the KRIS portfolio of outputs is the impact of macro factors on the company’s creditworthiness, and this represents a statistical relationship between key risk and macro factors and the performance of the company.

It can be seen clearly from the graphic above that low oil prices had a significant impact on Pacific’s probability of default and the spikes in KDPs were in line with falling oil prices.

The changing landscape had a direct and debilitating impact on Pacific Bond Spreads as well, as can be evidenced by the graph below, where the spreads moved from 7% in 2014, already very high, to almost 70%, just before default, and then market sentiment on recoveries were reflected in the bond prices falling to USD 13.

This point is further accentuated by the following figure which outlines the bond price history for all Pacific outstanding bond issues. It is evident that at the time of default, all bond prices, irrespective of maturity, converge to the recovery estimate that the market expects.

Another indicator that is very valuable as an early warning signal is a comparison to the industry peer group, which in the case of Pacific is the Energy peer group. It can be seen clearly in the graph below that Pacific’s one-year default probability moved from below the median level of the peer group to well above it in 2015. This is another warning, more than a year before default, to exit from any holdings of Pacific.

Finally, a critical indicator that is provided by KRIS is the linking of macro factors to default probability functions, and an analysis of Pacific shows that their KDPs are directly linked to the the JPY/USD exchange rate, Oil prices, , the Canadian Stock Index 2 year return, and the European Stock Index 2 year return. Since the performance of this organization was directly related to Canadian stock market performance, a drop in this macro factor indicator essentially meant that the KDPs of Pacific moved in line with a drop in the Canadian stock market 2 year return. The figure above identifies the various macro factors that drove the creditworthiness of Pacific, and the figure below identifies the relationship between Canadian stock 2 year return and Pacific KDPs.

The KRIS default probability models are benchmarked on more than two million observations of firms of all types. The total number of defaults used in the current version 6.0 models is more than 2,600. The unparalleled volume of data and the research insights of Kamakura’s Managing Director Prof. Robert Jarrow make the KRIS default probability service the most accurate early warning credit risk assessment indicator framework available. That is one of the reasons why Credit Magazine named both KRIS and the Kamakura Risk Manager Software package “Innovations of the Year”. For more information about KRIS default probabilities, please contact your Kamakura representative or e-mail Kamakura’s credit experts at info@KamakuraCo.com.

Copyright ©2016 Suresh Sankaran