Why the Benefits of Cheaper Oil Outweigh the Drawbacks

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1 Why the Benefits of Cheaper Oil Outweigh the Drawbacks By David Leduc, CFA Ben Li, CFA Andrew Fahey, CFA Thomas Higgins, PhD Standish Mellon Asset Management Company LLC World oil prices have plummeted more than 50% from their 2014 highs. Cycles of shortage and surplus characterize the entire history of oil. EXECUTIVE SUMMARY Daniel Yergin Oil prices have tumbled by more than half since mid-2014 due to a combination of supply and demand factors as well as market positioning. Although there will be winners and losers, we believe the decline in oil prices will be a net benefit to the global economy. Oil exporters with large dollar denominated debts could pose risks to financial stability in a strengthening dollar environment. We expect non-energy names in the high yield and emerging market space to outperform as oil prices stabilize. We believe US inflation-linked bonds will also benefit from stabilizing oil prices given their valuations and lack of credit risk. GAUGING THE IMPACT OF FALLING OIL PRICES World oil prices have plummeted more than 50% from their 2014 highs (Figure 1). This has implications for the global macroeconomic outlook, monetary policy at some of the major central banks and financial market performance. Although there will be winners and losers, we believe the decline in oil prices will prove to be a net benefit to the global economy and will create opportunities in the fixed income markets in Of course, falling oil prices will have consequences for oil producers, including the shale oil industry in the US, which has been an important contributor to investment and job growth in recent years. Lower oil prices will also aggravate disinflationary forces in places such as Europe and Japan. Perhaps most worryingly, the decline in oil prices will keep downward pressure on the currencies of some of the major oil exporters, which increases the vulnerability of those countries and companies with large dollar-denominated liabilities. However, from our perspective, these negatives will be more than offset by the positive impact of lower oil prices on the global economy. The top 10 net oil exporters represent less than 10% of world GDP, compared to the top 10 net oil importers which account for 55% of world GDP. In general, oil importers have a higher propensity to

2 OUTWEIGH THE DRAWBACKS // 2 consume and invest than oil exporters. Thus, we would expect the transfer of wealth from exporters to importers to provide a boost to global GDP of roughly a half of a percent in In addition, lower oil prices should give some of the major central banks more leeway to pursue easy monetary policy to encourage growth. Figure 1: Oil Prices Plummet The decline in oil prices has been driven by a combination of supply and demand factors as well as market positioning. U.S. Dollars per Barrel Brent Crude Oil Prices 50% Decline from June Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Source: Thomson Reuters as of January Nevertheless, financial market volatility is likely to remain elevated until the full effect of lower oil prices becomes clear. Indeed, the S&P VIX Volatility Index has doubled from around 11 last summer to more than 20 in mid-january. The most adversely affected areas of the fixed income markets have been the high yield companies and emerging market countries that have direct ties to the oil and gas industry. Yet, even unrelated sectors, such as the market for Treasury Inflation Protected Securities (TIPS), have been hurt as inflation expectations decline. Eventually, as oil prices stabilize, we believe some of these sectors will present opportunities to investors. WHY HAVE OIL PRICES COLLAPSED? The decline in oil prices has been driven by a combination of supply and demand factors as well as market positioning. Global supply has risen mostly due to increased US shale production, which has grown by 1 million barrels per day (bpd) in each of the last three years and is projected to grow 1 million bpd this year. At the same time, global demand has softened with the International Energy Agency slashing its 2014 demand forecast nearly in half from million bpd in January 2014 to just 700,000 bpd by last summer. The IEA is forecasting an increase in demand of 900,000 bpd this year. 1 The hedging activities of producers exacerbated the price move as did the November decision by the Organization of Petroleum Exporting Countries (OPEC) not to scale back output. Despite the ongoing weakness in oil prices, key members of OPEC including Saudi Arabia, the United Arab Emirates (UAE), Kuwait and Qatar have indicated a continued reluctance to cut production. While sub-$80 oil is below most OPEC member nation s breakeven price to balance their budgets, this core group can withstand low prices for some time due to their large currency reserves (Figure 2). 1 The International Energy Agency World Energy Outlook. November 2014.

3 OUTWEIGH THE DRAWBACKS // 3 In the absence of production cuts, oil prices could fall further especially during the winter and spring months when consumer demand weakens and refineries shut down for maintenance. However, we believe oil prices will recover modestly in the second half of 2015 as producer hedges roll off, demand picks-up with the summer driving season, and US shale suppliers begin to slow output. Sub-$60 West Texas Intermediate (WTI) crude could reduce shale production by between 25-50% this year. Figure 2: Oil Breakevens Oil Price per Barrel (U.S. Dollars) $200 $180 $160 $140 $120 $100 $80 $60 $40 $20 $0 Libya Iran Algeria Break-even Oil Price Nigeria Venezuela Saudi Arabia Iraq Russia UAE Qatar Kuwait $50 Norway The main beneficiaries of low oil prices are oil importing countries. Source: IMF as of December WHO WINS AND WHO LOSES? The main beneficiaries of low oil prices are oil importing countries. China surpassed the US as the largest net importer in 2013 with 5.6 million bpd. By our estimate, the decline in Brent Crude oil prices to $50/barrel could add as much as 0.7 percentage points to Chinese GDP in 2015 if it is sustained. The comparable figures for the US would be 0.6 percentage points to US GDP. Unfortunately, these gains will partly be offset by losses for the largest net exporters such as Saudi Arabia, Russia, the UAE, and Kuwait. Yet, because net oil importers generally have a higher propensity to consume their windfall rather than save it, we believe the net add to global GDP in 2015 could be more than a half a percent. We are currently forecasting world GDP growth of 3.4% this year compared to 3% for Although we are relatively sanguine about the impact of lower oil prices on the global economy, we are concerned about the risks to financial stability posed by certain emerging market (EM) oil exporters with large dollar-denominated debts, especially in a strengthening dollar environment. This dynamic is most evident in Venezuela and Russia, but it also applies to Colombia, Mexico, Kazakhstan, and Brazil. The pressures on these markets will most likely manifest itself in increased currency volatility. Yet, Venezuela could face the risk of outright default given its fixed exchange rate. Default risk also remains a concern for some of the most highly levered names in the US high yield space. The energy sector, which makes up roughly 13% of the Merrill Lynch High Yield index, has been one of the most aggressive borrowers in recent years with issuance topping $50 billion in 2014 (Figure 3: High Yield Energy Issuance Rising). Even so, we do not expect to see a large wave of defaults in 2015 perhaps five out of the 180 names in the index given hedging, liquidity and cuts to capital expenditure. However, that amount could double or maybe even triple in 2016 if $50/barrel oil persists. In the meantime, we anticipate that the pace of consolidation will start to pick up this year as stronger companies purchase liquidity constrained companies on the cheap.

4 OUTWEIGH THE DRAWBACKS // 4 Figure 3: High Yield Energy Issuance 60 Annual High Yield Energy Issuance We believe the move in oil prices will be one of the most important factors shaping financial market performance in Billions of U.S. Dollars Source: Bank of America Merrill Lynch as of January HOW CAN WE TAKE ADVANTAGE? We believe the move in oil prices will be one of the most important factors shaping financial market performance in For the time being, we are keeping risk budgets low given heightened market volatility, but we are positioning ourselves to take advantage of the move in oil in several ways. First, although the energy sector is likely to dominate high yield performance in 2015, the market is becoming increasingly comfortable with credits outside energy. For example, the travel, consumer discretionary, and auto sectors are expected to benefit from continued US growth. There also remains strong demand for BB paper from investment grade crossover buyers. Unfortunately, non-energy credit spreads are much tighter at around 448 basis points (bps) compared to 828bps in the energy sector. 2 Furthermore, large outflows still have the potential to destabilize the sector with forced selling of energy and greater selling of non-energy, liquid credits. Thus, caution is still warranted. The same is true in emerging markets where the negative trend was in place even before the collapse in energy prices. Lower oil prices have simply heightened the risk of downgrades and defaults. This is especially true for those sovereigns and corporates who have borrowed heavily in dollars and face a potential currency mismatch between their assets and liabilities as the dollar strengthens. As a result, we believe it may be premature to add significant exposure emerging markets at the present time. We are a bit more bullish on the US TIPS market given that it is not subject to the same credit risk as emerging markets or high yield. In addition, our valuation models suggest it is one of the cheapest areas of the fixed income markets. However, even here, we really need to see some stabilization in oil prices before TIPS breakevens move meaningfully higher. 2 Merrill Lynch High Yield Index as of January 20, 2015.

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