# **I. Introduction**

Economists have long explored how debt levels affect stock returns. The literature, dating back at least to Modigliani and Miller (1958), showed that in a frictionless world, the value of a firm is unaffected by how a firm is financed. In the presence of frictions, firms face a trade-off linked to the benefits and costs of debt financing (see Harris and Raviv, 1991).<sup>2</sup> The equity of a levered firm is riskier than the equity of an otherwise identical firm with less leverage. The value of equity falls more when the firm leverage is higher for a given fall in the value of the firm’s assets.<sup>3</sup> The shock caused by the Great Recession allowed for the analysis of the role of debt levels in mediating the impact of the Recession on firm performance.<sup>4</sup> In the present paper, we exploit the 2020 oil crash to explore the role of debt in mediating the effect of a fall in the value of the firm’s main assets, oil reserves, on stock returns of oil and gas firms in the United States.

Oil firms in the U.S. have accumulated a significant amount of debt during the period of relatively high oil prices. Data from Compustat reveal that the simple average total debt for all available U.S. oil firms jumps from about 25% of total assets during 2009-2014 to about 40% during 2015-2019. The COVID-19 pandemic and an oil price war sent oil prices to an all-time low in the first half of 2020. Amid the collapse in oil prices, commentators have raised concerns about the sustainability of debt accumulated by oil firms.<sup>5</sup> They argued that lower prices combined with high debt levels could lead to a cascade of bankruptcies.<sup>6</sup> Moreover, the size of the oil and gas sector has grown rapidly, raising concerns about the potential spillover effect stemming from bankruptcies in the sector to the rest of the economy and financial markets.<sup>7</sup> The findings from existing research contradict the conventional wisdom that lower oil prices have traditionally been good for the U.S. economy.<sup>8</sup> This paper specifically tests whether oil price fluctuations have a differentiated effect on levered oil firms. Because of the theoretical predictions 2 The trade-off is as follows. On the one hand, higher debt levels effectively increase the equity share of managers, in turn reducing agency costs. On the other hand, higher debt levels increase risk-taking of equity holders.

3 See Merton (1974) and Leland (1994, 1998) for the traditional theoretical framework to analyze corporate debt value and optimal capital structure. Absent commitment to leverage policy, important agency frictions determine the firm’s choices in terms of leverage. Recent theoretical contributions by Admati et al. (2018) show that without commitment, equity holders will adjust leverage to maximize the current share price rather than total firm value. Demarzo and He (2021) find that bond investors anticipate future leverage increases and require significant credit spreads even when the distance to default is large. The tax benefits of future debt increases are fully dissipated, and equilibrium equity values match those in a model where the firm commits not to issue new debt.

4 Several papers exploit the great recession to explore the role of debt on firm behavior. Campello et al. (2010) find that financially constrained firms planned deep cuts in employment and spending. Giroud and Muller (2017) find that more highly levered firms experienced significantly larger employment losses in response to decline in local consumer demand.

5 See Reuters (2020a); Washington Post (2020).

6 Early in the pandemics, bankruptcies among oil and gas companies in North America have risen (Reuters, 2020b; Haynes and Boone LLP, 2020). Given the concern, the Trump administration even considered giving direct aid to oil firms (Wall Street Journal, 2020).

7 Data from US Energy Information Administration website show that US crude oil output has more than doubled from about 5 million barrels per day (mb/d) in 2008 to over 12 mb/d in 2019. 8 See for instance Nguyen et al. (2020) and Bjørnland and Zhulanova (2019).

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