Oil And The High Yield Market by Jennifer Ponce de Leon, ColumbiaManagement
Size of the Energy Sector
Because the energy sector is a large component of the U.S. high yield market relative to some other asset classes, the market has received increased scrutiny due to recent declines in oil prices. Prior to the recent sell off, energy accounted for more than 15% of the high yield market, making it by far the largest industry (healthcare is the second largest at approximately 8.5%). Energy accounts for approximately 11% of the U.S. investment grade market (based on the Barclays U.S. Investment Grade Corporate Index). However, the sub-sectors that are most sensitive to commodity prices – Exploration and Production (E&P) and Oilfield Services – account for roughly 4% of the investment grade market (versus approximately 9.5% of the high yield market). In the equity markets, energy accounts for approximately 8.5% of the S&P 500 Index.
Source: BofA Merrill Lynch
Energy has historically been a large component of the high yield market because of the underlying asset value and the continuous need for capital required by energy companies to replace their oil and gas production. In addition, the U.S. shale revolution has brought a number of new companies to market for growth. Furthermore, over the past four years, oil has averaged around $90/barrel (bbl), oil price volatility was low by historical standards, the high yield market was conducive for new bond issuance and rates were low. The energy sector took advantage of this favorable environment and became an increasing portion of the new issuance and overall market.
Source: JP Morgan. Past performance does not guarantee future results.
Recent Developments in the Oil Market
Oil peaked around $107/bbl in June and has dropped nearly 40% to $66/bbl. A number of factors contributed to the drop. There has been a lot of press about the rapid increase in U.S. oil production driven by new shale regions. Production increased from approximately 5 million bbls/day in 2008 to approximately 8.8 million bbls/day currently. This new supply had been offset by increasing global demand and almost 4 million bbls/day of outages from countries like Iraq, Libya, Syria, Yemen and Iran. Recently global production has picked up (fewer outages) while demand growth has slowed along with economies in Europe and China. Historically, Saudi Arabia has helped balance the market but that changed during the recent OPEC meeting. Saudi Arabia is a low-cost producer (excluding social costs in the budget) and has amassed a significant asset surplus over the past number of years. Rather than give up share to higher cost producers (including some of the U.S. shale regions), Saudi Arabia decided to hold production steady. Without Saudi Arabia balancing the market, the resulting oversupply has driven prices lower. There remains an ongoing debate as to whether Saudi Arabia refrained from reducing their production in order to flush out the high cost producer and maintain market share, or whether the action was driven by geopolitics and desire to apply economic pressure to Iran and ISIS to name a few. Regardless, the result is lower oil prices and higher volatility until the market is more balanced. Going forward, monitoring changes in supply from capital expenditure reductions, OPEC cuts and unplanned outages will be important to help determine the direction in oil prices. We will also be watching to see if there is a positive demand response from lower prices.
Source: Bloomberg. Past performance does not guarantee future results.
Valuation and Performance Impact on the Energy Sector and High Yield
The impact of lower oil prices has been felt directly by high yield energy bonds and the high yield market. Since the beginning of September, high yield energy bonds have posted a return of -11.2% and yields widened by 331 basis points (bps). During this same period, the high yield market (including energy) returned -2.6%. But when energy is excluded, the return of the market improves to -0.95% and the yield and spread of the market tightens by nearly 40 bps.
Source: BofA Merrill Lynch.
The energy industry is comprised of four subsectors. As evidenced by the yield in the above chart, the impact from the drop in oil prices has been most acute within Exploration and Production (E&P) and Oilfield Services (which collectively account for approximately 9.5% of the market). The remaining 4.5% of the energy sector (Midstream and Refining) is less impacted by changes in commodity prices, but not immune.
New issuance had been robust for E&P companies. In some cases, the high yield companies were early movers in a shale region and acquired what we would call the core “A” type properties that have lower costs than other parts of the region or U.S. But in other cases, especially with some of the more recent new issuance, the properties were in higher cost fringe areas. Overall break-even prices in the U.S. shale regions have a wide range of $40-$80/bbl, making the assessment of asset quality critical when investing in the sector. Prior to the drop in oil prices, energy bonds traded with minimal differentiation despite differences in asset quality, leverage, hedging levels and full cycle costs. As you would expect, the companies with the higher break-even costs, high leverage and limited hedges have been negatively impacted the most. Additionally, with the market in oversupply, growth in the higher cost basins is likely to slow, resulting in lower demand for oilfield services including rigs and completion services.
If lower oil prices persist longer than expected, they will not only impact high yield market performance, but also, we could see an increase in default rates. Our internal expectations for defaults are 2.45% in 2015 and 3.45% in 2016. In the event oil prices were to remain low into 2016, the default rate is likely to head higher than our current projections in 2016 due to an increase in energy defaults.
We believe the decline in oil prices will ultimately create compelling opportunities within the energy sector. It could also serve as a tailwind for other sectors and stimulus to the overall global economy which is favorable for credit markets. We will look to be opportunistic in the sector as we have the resources to analyze and identify strong risk-adjusted fundamentally driven opportunities to take advantage of the volatility in the market. Our focus continues to be on asset quality, the company’s full cycle costs, leverage and capital needs going forward. Additionally, when prices drop, liquidity and understanding the dynamics around bank borrowing bases and redeterminations is critical. We continue to believe that the energy sector can provide solid asset coverage, attractive M&A candidates and in some cases, the potential for upgrades to investment grade. Given the challenge in predicting the timing of oil price changes, we are currently positioning for an extended period of lower oil prices; but we acknowledge that if oil prices sustainably improve, it could lead to stronger than expected high yield market performance.
Given the stable fundamentals of the majority of the high yield asset class with below average default rate expectations, limited refinancing risk, low overall levels of leverage, and reasonable earnings outlook, we still view high yield as an attractive investment alternative to other core fixed income products. However, we believe high yield will have a difficult time outperforming the equity market.
Information as of December 2, 2014 unless otherwise stated. All data for the high yield market is based on the BofA Merrill Lynch U.S. High Yield Cash Pay Constrained.