Over the last six months the oil price has fallen sharply. This has been attributed variously to fracking in the US causing a rise in the supply of hydrocarbon energy, concerns about a slowdown in the Chinese economy leading to weaker demand, high oil prices prompting a structural shift in energy efficiency and resistance by Saudi Arabia within OPEC to cut production to support prices. Whatever the underlying cause, the low oil price has implications for the high yield market, especially in the US where around 18% of high yield issuance in 2014 originated from the energy sector.
Energy positioning within the strategy
In late 2014, we reviewed our positioning in high yield Energy and stress tested our holdings based on a long-term WTI Oil price of $60/bbl. As a result, we exited four energy positions – Sandridge Energy, Energy XXI, Tervita and California Resources Corp (Calres). For the first three we projected potential default scenarios at the end of 2015/early 2016 and, therefore, further downside risk. We decided to exit Calres despite its low cost structure and liquidity because the company is unhedged and results are likely to be volatile in the medium term.
However, it is important not to write off the energy sector entirely. There will be plenty of companies that are able to tolerate the volatility in oil and gas prices and the risk premium that is reflected in their yields can offer an attractive opportunity. That is why we reviewed several higher quality names that were better positioned to withstand a low oil price environment due to a low cost profile, solid balance sheet, significant liquidity and an equity cushion. As a result we have added Chesapeake Energy and Hilcorp Energy as names that have sold off, but also offer downside protection. At 20 February 2015, the yield to worst on these two bonds was respectively 5.0% and 5.8%, with the yields declining (prices rising) since we made the purchases. The table below shows the HY energy weight in the fund.
The plight of oil services
Having lots of debt may stop some capacity exiting as producers operate to earn every dollar of cash they can, hoping for an upturn, but in the process they will try to force down costs. Just as supermarkets squeeze their suppliers, we anticipate oil margins at oil services companies being squeezed by oil explorers and producers that are seeking to cut costs. Daily prices for rigs are already tumbling and many producers are announcing big cuts to capex budgets as they seek to preserve free cash. In anticipation of a difficult near term for this sub-sector, we now hold no oil field equipment and services debt.
Similarities with 1986
Lower oil prices are contributing to lower inflation, which in turn is contributing to lower yields. Some commentators are interpreting this as a signal that the global economy is weak. It is not uncommon for a sharp drop in the oil price to occur without presaging a recession, however, as happened in 1986. This view is shared by Morgan Stanley, the investment bank, which has pointed out that 1986 offers many similarities to today: US credit spreads initially widened, Treasury bond yields fell and the yield curve flattened – the following years would see the economy do reasonably well. The chart below shows the direction of the oil price in 1986 overlaid with today’s oil price movement. If the oil price follows a similar pattern, then it may level out at current levels. Equity markets rose for several more years following 1986 and a strong equity market is usually helpful for the high yield bond market in general in terms of investor sentiment, capacity for M&A activity and IPO activity.
Impact for rest of the portfolio
The oil price decline is good news for global growth as it should act as a tax cut for consumers, leading to a shift in wealth from oil-exporting countries to countries with a high propensity to consume. The US and Europe, in particular, should be net beneficiaries. Oil is an important primary input for many products, which together with tumbling transport and energy costs means the positive ripple-through effects on the broader economy are substantial. Spreads on high yield, however, have been dragged wider in response to worries about the energy sector and we believe this has created better value within the high yield market.
Improving flow picture
Higher spreads on high yield bonds come at a time when yields on core government bonds appear to be anchoring at lower levels, a consequence of lower inflation levels together with deliberate policy action by the European Central Bank (ECB) to purchase sovereign bonds. Unlike investment grade markets, the high yield market may not benefit as directly from the “crowding out” effect of the ECB’s quantitative easing program, but the second order effect could be just as large. The first beneficiary will be BB-rated (which is easier for institutions to move down into) but ultimately this will have a knock-on impact on B/CCC pricing. With fund flows starting to pick up, the yield and spread enhancement offered by high yield looks increasingly attractive in a world of negative or low government bond yields. Already, in recent weeks, there has been a shift towards positive flows within both the European and US high yield sectors.
Petrobras event risk
Petrobras, the Brazilian oil and gas giant, has been the subject of an ongoing corruption investigation, which together with the collapse in the oil price, has led to negative sentiment towards the company and concern about its accounting practices. The company was downgraded to just one notch above investment grade by Moody’s and Fitch, the credit rating agencies, in early February 2015. A company’s credit rating for index purposes reflects the majority view of the big three ratings agencies. With around $50bn of outstanding debt a downgrade to sub-investment grade status could lead to a flood of high yield energy paper onto the market as investors who are restricted from owning non-investment grade bonds are forced to sell. This is all the more reason for our preference for higher quality high yield within the energy sector.
Kevin Loome is Head of US Credit and portfolio manager of the Henderson Horizon Global High Yield Bond Fund.
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