Energy and the High Yield Market

Transcription

1 Energy and the High Yield Market Q Newsletter Formula for success: rise early, work hard, strike oil J. Paul Getty ( ) A vital commodity? Crude oil prices have plummeted since mid2014 (see Chart 1), triggering a decline in energy sector bonds. The decline in crude appears to be precipitated by concerns that growth in global supply, predominately driven by North America, could potentially outpace weak demand. Saudi Arabia, the de facto OPEC leader, indicated that it would not cut production in response to falling crude prices. This facilitated a further decline in crude prices and fueled investor anxiety about high defaults and low recoveries in the high yield energy sector. As a result, the high yield market exhibits a clear bifurcation between energy and nonenergy credits. Spreads for the energy sector are nearly 70% wider than spreads for the rest of the market. Accordingly, we thought a thorough analysis of the sector would be a worthwhile effort. This newsletter will first provide some background on the high yield energy sector by describing historical trends, its current composition, and current characteristics. Next, we will briefly explore the key forces affecting the demand and the supply for crude oil, and the implications for the commodity s future price. Given what we learn, we will then compare various energy sector default scenarios to the current valuations (spreads) to determine whether the sector and the broad high yield market represent interesting investment opportunities. Chart 1: Crude Oil Prices ($/barrel, Brent) Dec13 Jan14 Feb14 Mar14 Apr14 May14 Jun14 Jul14 50% Aug14 Sep14 Oct14 Nov14 Dec14 $57 I. Energy sector background Over the past 20 years, the energy sector has comprised between 5% and 15% of the high yield market, and currently represents 13.6% (see Chart 2). Energy comprises a larger portion of the most popular high yield ETFs, representing 16.3% of JNK and 14.1% of HYG at the end of Chart 2: HY Market Composition 100% 90% % 70% % 50% % 30% 20% 10% 0% Chart 3 dissects the current energy sector into four different industries. The exploration & production ( E&P ) and equipment & services ( E&S ) industries are directly exposed to oil price changes and have been negatively affected by recent declines. Chart 3: HY Market Composition Energy Only 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 13.6% 0.6% Refining & Other 3.9% Distribution Non Energy Energy 1.6% Equipment & Services (E&S) 86.4% 13.6% 7.5% Exploration & Production (E&P) 0.0%

2 Chart 4 isolates these two oil price sensitive industries and dissects them by credit rating. The exploration & production combined with the equipment & service sectors represent 9.1% of the total high yield market. Of this 9.1%, 5.3% is composed of credits rated B, CCC, or lower. It is this 5.3% of the market that we believe is most at risk. Chart 4: HY Market Composition E&P and E&S Only 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Historically, the yieldtoworst ( YTW ) for the energy sector has been lower than the rest of the market. As shown in Chart 5, this has reversed in a major way since oil prices began to tumble in mid2014. At year end, the YTW for energy credits was 9.3% compared to 6.2% for the rest of the market. Chart 6 depicts a similar story by highlighting spreads over treasuries rather than YTW. Chart 5: HY Market YieldtoWorst 20% 15% 10% 5% 3.8% 4.0% 1.3% NonEnergy (avg 9.4%) Energy Only (avg 8.7%) BB & Above Single B CCC & Below Most At Risk % 6.2% Chart 6: HY Market Spread Over Treasuries (basis points) Using the data from Charts 5 and 6, Chart 7 shows the historical yield and spread premiums relative to the broad market. In most periods, the energy yields and spreads have been lower than the market average (i.e. energy has exhibited higher valuations). Today, energy bonds exhibit yields/spreads more than 50% above the market average (i.e. energy has lower valuations today). Chart 7: HY Energy Premium/Discount Energy divided by nonenergy Historically, energy was often considered a defensive sector. Part of the reason that high yield energy has historically offered lower yields/spreads than the average high yield bond is because energy bonds have a history of low defaults. As shown in Chart 8, the average default rate for the high yield energy sector over the past 20 years was 1.4% compared to the market average of 3.1%. In fact, the energy sector experienced zero defaults in 6 of the past 20 years. The default rate for energy exceeded the market average in only 3 of the past 20 years, and only once in a meaningful way in the energy default rate was 13.2% as 16 bonds defaulted. TransAmerican Energy was H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 8 2,000 1,500 1, Energy is Cheap Energy is Expensive 0 NonEnergy (avg 0) Energy Only (avg 498) % 150% 125% 100% 75% 50% Spreads Over Treasuries (avg 84%) YieldtoWorst (avg 94%) 25% % 151%

3 the largest default, comprising more than onethird of the total par value of all energy defaults that year. Crude oil prices had tumbled in the two years leading up to, trading as low as $9.64 per barrel in late 1998 (Brent) and severely stressing E&P and service companies. Chart 8: Default Rate Last 20 Years 15% 10% 5% 0% HY Market HY Energy Yr Avg 3.1% 1.4% II. Crude Oil Prices: Demand Consumption data through 2014 is not yet available by region. Historically, global crude oil consumption has grown at approximately onethird the pace of real GDP over time as shown in Chart 9. The World Bank s forecast of real GDP in the coming years is roughly 3%, which implies a 1.0% increase in crude oil demand assuming this historical relationship holds. For perspective, the historical demand growth for the past 10, 20, and years are +1.3%, +1.5%, and +1.3%, respectively (annualized). Emerging markets generated nearly all of the demand growth in the past years. In 1973, developed countries consumed about 38 million barrels per day versus million barrels per day currently. Emerging markets, however, have increased consumption over the same period by more than 200% from 16 million barrels a day to 51 million barrels a day (see Chart 10). Chart 10: Total Global Crude Oil Consumption millions of barrels per day Emerging Markets Developed Markets 91 (1.3% CAGR) 51 (2.9% CAGR) (0.0% CAGR) China has been the primary contributor to emerging market demand growth, but as shown in Table A, other emerging market countries have also increased demand considerably. Table A: 10 Most Populous Emerging Markets consumption in millions of barrels/day Chart 9: Global Growth Over the Past Years Real GDP and Crude Oil Consumption Cumulative 250% 200% 150% Global Real GDP Growth 210% 100% 50% Global Crude Oil Consumption 64% 0% H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 8

4 A key variable for crude oil prices going forward is whether this demand growth from emerging markets can persist. Forecasting near term progress of developed market economies is difficult enough, let alone forecasting emerging market progress. Questionable governance practices, inconsistent legal protections, and geopolitical unrest are among a litany of risks that are more prevalent in emerging markets than in developed markets. In the long run, however, emerging markets have exhibited a tendency to converge with developed markets on a per capita basis. GDP per capita for emerging market countries, for example, has converged with developed market countries. In, China s GDP per capita was only 13% of the US GDP per capita but it was only 3% ten years ago and 1% twenty years ago. The pace of convergence is difficult to predict but we expect general convergence to continue going forward. In terms of crude oil demand, the per capita consumption rates are significantly higher for developed markets than for emerging markets. Chart 11 highlights the per capita consumption levels for the US (21.8 annual barrels/person), the average for other developed countries (12.7), and the two largest emerging market countries (China at 2.9 and India at 1.1). Chart 11: Per Capital Consumption annual barrels/person Chart 12: Projected Increase in Global Demand assuming per capita consumption in China and India converges upward (millions of barrels/day) % of DM Avg (ex US) % of DM 75% of DM Avg (ex US) Avg (ex US) Level of Convergence To sum up, we use +1% as our estimate of total consumption/demand growth going forward, which equates to about 1 million barrels a day of incremental demand. This represents a slight discount to the historical average and represents about onethird of forecasted real GDP growth which would be consistent with history. III. Crude Oil Prices: Supply OPEC, Russia, and the US are responsible for more than twothirds of total global crude oil production, as depicted in Chart 13. Chart 13: Global Production by Region (2014) % of DM Avg (ex US) US Other Developed (wtd avg) China and India have enormous populations representing about 35% of the world s population between the two. Any upward convergence in per capita oil consumption in these countries, therefore, would have a meaningful impact on total global demand. Currently, China s per capita consumption is 22% of the developed market average (excluding the US which we will consider an outlier); India s per capita consumption is 9% of the developed market average. Chart 12 highlights the increase in global demand assuming China and India s per capita consumption converges toward the developed market average. 2.9 China 1.1 India Canada 5% Rest of World 25% US 13% Russia 16% OPEC 41% Global production, however, has undergone a notable mix shift over the past 5 years. Table B highlights how each of these producers has grown over the past 5 years. The US alone represents 59% of global growth in the past 5 years and 84% of global growth in the past year. H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 8

5 Table B: Global Production Growth Last 5 Years in millions of barrels/day Within the US, most of the production growth has come from shale regions as hydraulic fracturing ( fracking ) techniques have proliferated. As shown in Chart 14, nearly all US incremental production over the past 5 years has come from four major shale regions the Bakken, Eagle Ford, Niobrara, and Permian regions. In fact, of the 7.4 million barrels/day increase in production globally over the past 5 years, more than half has come from these four US shale oil regions. Chart 14: US Production by Region millions barrels/day Four Major Shale Regions Everywhere Else It is important to consider where production growth has come from because different regions have different characteristics. As such, changes in crude oil prices affect the dynamics of various regions differently. As it relates to US shale regions, one characteristic deserves particular attention: ultrahigh decline rates oil they produce declines at between 2% and 5% per year. 1 Once a conventional well is drilled, the ongoing cash costs of production are predominately labor and energy. Production at existing conventional wells, therefore, remains relatively constant irrespective of the market price for crude oil so long as production profits exceed the ongoing cash costs. In shale wells, however, first year decline rates are typically % to 75%. Maintaining production requires constantly exploring/drilling new projects, which can be uneconomic when crude prices are low. At current oil prices, it may be economic for most existing wells to continue producing but it may not be economic for many shale oil producers to continue drilling new wells. High yield E&P producers have already cut 2015 capital expenditure budgets by a remarkable %; investment grade E&P producers have cut capex budgets by 25% 2. We believe this is a precursor to lower US production growth. If oil consumption grows and oil production from US shale regions moderates, one might wonder if other regions have the ability to increase production. As we observed in Table B, however, OPEC, Russia, and the rest of world grew production at a rate slower than demand and these three regions account for over % of total crude oil production. It is not logical that OPEC members with spare capacity would increase production in an environment with low crude prices if they did not increase production in an environment with high crude prices. Also, many regions around the world with low cost production (e.g. OPEC, Russia) are politically unstable. Libya, for example, has experienced a precipitous drop in production amid ongoing conflicts in the country which has the largest proven reserves in Africa. Nigeria, the largest current producer in Africa, and Venezuela, the largest current producer in South America, are both on the brink of economic turmoil. The Russia/Ukraine conflict is also unsettling, and the geopolitical landscapes in Iran and Iraq are persistently volatile. The main takeaway is that many of the lowcost producers of crude oil are in regions with a lot of geopolitical instability. Exploration and production costs are not the only factors that companies must consider when allocating resources to these regions. For perspective, Chart 15 highlights the political risk score for OPEC countries compared to the developed market average. As an oil well ages, it produces less oil. The pace at which production falls is referred to as the decline rate. An article in Fortune magazine notes In conventional wells, whether in the Middle East, the Gulf of Mexico, or the North Sea, the wells operate on extremely long cycles. Typically, the amount of crude Source: JPMorgan Global Credit Research H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 8

6 Chart 15: Political Risk Score for OPEC Countries Economist Intelligence Unit measure of overall political stability High Political Risk Low Political Risk Developed Markets Wtd Average (16) Additionally, because crude oil production represents a significant portion of these countries economies, low oil prices only add to economic and political stresses. Crude oil price declines benefit net importers at the expense of net exporters. Table C highlights the estimated effect that the decline in crude prices would have on various regions GDP. Table C: Crude Price Decline Impact by Region World Bank Estimates To sum up, the market observes increases in crude oil inventory and prices drop accordingly because investors fear short term oversupply. Taking a longer term outlook, however, oil demand seems likely to grow at a modest rate. The market appears to assume that high decline rate wells in the US combined with stable production in politically risky areas will be adequate to meet this demand. Current prices are straining the economics of current projects, which is likely to result in reduced supply/production growth. The duration of this cycle is uncertain but we believe the high cost producers could be marginalized rather quickly. Over the last 20 years, crude oil prices have fallen more than % in a 12 month period just three times. It took 5 months for prices to recover following the decline in 1998 ; it took 15 months for prices to recover following the decline in 03; and it took 26 months for prices to recover following the decline in There are too many variables to precisely predict the right price of oil, but we estimate that the average producer would earn adequate returns with oil prices around $/barrel (portrayed in Chart 16). We view this as a reasonable equilibrium price. Chart 16: Return on Equity ( ROE ) Oil Price High ROE "Required" ROE Low ROE ROE More projects are economic (supply should rise) Fewer projects are economic (supply is unlikely to keep pace with demand) IV. HY Energy Default Scenarios and Valuation While we are confident that crude oil prices will eventually rise, we are less confident about the duration of eventually. John Maynard Keynes famously quipped, The market can stay irrational longer than you can stay solvent. As such, we found an interesting default rate scenario provided by JPMorgan, which in our experience does exemplary work on the high yield market. The firm s base case is for $ oil, which is consistent with our estimate of the oil price needed for marginal producers to earn adequate returns. Table D highlights the company s default rate estimate for the energy sector under various oil price scenarios. The first table assumes managements take no corrective actions, which appears highly unlikely given the reported cuts to capex budgets. The second table is more relevant, as managements appear to react prudently to the low oil price environment. In this case, energy sector defaults range from 14% in 2015, 18% in 2016, and 720% in 2017 under the three scenarios. H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 8

7 Table D: Energy Sector Default Rate Scenarios JPMorgan Estimates Note: All data as of December 31, As of February 28, 2015, spreads have tightened by roughly 50 basis points so excess spreads under each scenario are lower by this amount as of 2/28/15. Table F: Default Rate Scenarios Compared to Spreads JPMorgan Estimates continued While Table D highlighted default rate scenarios for the energy sector only, Table E applies these scenarios to the total high yield market. Even under the Horror Show scenario, the default rate on the total market would peak at less than 5% in Table E: Total HY Market Default Rate Scenarios JPMorgan Estimates continued Finally, we need to assess these default scenarios in the context of spreads. High default rate environments can be lucrative if navigated appropriately and spreads are sufficiently wide. Table F summarizes the various default rate scenarios compared to the current spread in the market. Under the base case, for example, the default rate is 2.5%. Assuming a recovery rate of %, which is the historical average, the loss rate due to defaults would be 150 basis points [2.5% * (10.4)]. The spread on the high yield market is 500 basis points, so the excess spread, or the spread earned after losses due to defaults, would be 350 basis points. Table F shows the excess spread for each of the scenarios. Importantly, the excess spread even under the horror show scenario is well above zero. Summary There has been a lot of noise about energy and high yield bonds recently, especially from uninformed commentators in the financial press. Energy represents a meaningful but not dominant portion of the high yield market, especially after excluding companies that have little exposure to crude oil prices. With the large drop in crude prices in 2014, energy credit spreads have widened to historic levels relative to the rest of the high yield market. Our approach to navigating such an environment is highly opportunistic we believe some high yielding energy credits are at risk and some represent compelling investment opportunities. We believe current crude oil prices are well below longterm equilibrium prices, though the timing of reversion is difficult to predict. Even under highly pessimistic scenarios, however, the overall high yield market s impact appears quite manageable. Hotchkis & Wiley High Yield Research All investments contain risk and may lose value. Investing in high yield securities is subject to certain risks, including market, credit, liquidity, issuer, interestrate, inflation, and derivatives risks. Lowerrated and nonrated securities involve greater risk than higherrated securities. High yield bonds and other asset classes have different riskreturn profiles, which should be considered when investing. H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 8

8 Data sources: Chart 1: Bloomberg; Charts 27: BofAML, Bloomberg; Chart 8: JPMorgan; Chart 9: World Bank, BP Statistical Review, US Energy Information Administration, Bloomberg; Charts 10, 1314: BP Statistical Review, US Energy Information Administration; Charts 1112: BP Statistical Review, US Energy Information Administration, US Census Bureau, Bloomberg; Chart 15: Economist Intelligence Unit, Bloomberg; Chart 16: H&W. Tables AB: BP Statistical Review, US Energy Information Administration; Table C: World Bank; Tables DF: JPMorgan Hotchkis & Wiley. All rights reserved. Any unauthorized use or disclosure is prohibited. This material is for general information only, and does not have regard to the specific investment objectives, financial situation and particular needs of any specific person. It is not intended to be investment advice. This material contains the opinions of the authors and not necessarily those of Hotchkis & Wiley Capital Management, LLC (H&W). Certain information presented is based on proprietary or thirdparty estimates, which are subject to change and cannot be guaranteed. The opinions stated in this document include some forecasted views, which are believed to be based on reasonable assumptions within the bounds of current and historical information. However, there is no guarantee that any forecasts or views will be realized. Any discussion or view on a particular asset class or investment type are not investment recommendations, should not be assumed to be profitable, and are subject to change. H&W has no obligation to provide revised opinions in the event of changed circumstances. Information obtained from independent sources is considered reliable, but H&W cannot guarantee its accuracy or completeness. For Investment Advisory clients. H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 8