Is High Yield Today More Resilient to Oil Volatility? Not at Any Price

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Investors, myself included, continue to marvel at the low volatility regime. Measures of equity and bond volatility remain at or near all-time lows. As I’ve discussed in previous blogs, tight spreads and benign credit conditions support a low volatility environment.

Year-to-date, high yield and other spread products continue to produce solid returns. In the case of U.S. high yield, this is a bit surprising given the drop in oil prices, down around 10% year-to-date. After all, it was only 18 months ago that a plunge in oil prices, coupled with fears over Chinese growth, sent high yield plunging and credit spreads soaring. What has changed?

US Credit Spread

As it turns out, quite a lot. There are a number of reasons why high yield markets have been more resilient to lower oil prices:

1. Global economy on solid ground

Unlike early 2016, when investors fretted over the potential of China dragging down the global economy, most recent economic indicators point to stability.

2. Better quality in energy issuers

Today, low rated companies (CCC and below) make up a smaller portion of high yield energy issuers.

3. Smaller share of the high yield market

High yield energy is now 13% of the Bloomberg Barclays High Yield Index as opposed to 17% in early 2016. That is roughly a 25% drop in its contribution to high yield spreads.

4. Improved term structures

Energy issuers are less dependent on rolling over near-term debt. And as with all high yield issuers, companies continue to benefit from still low interest rates and easy financial conditions.

5. Lower production costs

According to research from Barclays, high yield oil and gas exploration and production (E&P) companies have slashed breakevens costs by approximately 30%, to roughly $50 per barrel. This is particularly true for those E&P firms centered in the Permian Basin in West Texas, where production costs tend to be the lowest in the continental United States.

All of this suggests that high yield is not as vulnerable to lower oil prices as it was in early 2016. Work from my colleague Miguel Crivelli confirms this view. Based on his research, when West Texas Intermediate (WTI) is between $40 to $50, high yield spreads are likely to be about 45% lower than what would have been expected based on the pre-2017 relationship. Put simply, high yield energy spreads are less sensitive to changes in oil today. For every dollar increase in oil prices, high yield spread in energy only moves two-thirds as much as it would have before 2017, when oil prices were in the same range.

That said, the fact that high yield has become more resilient does not mean the sector is now agnostic to the price of oil. At some price point, a good portion of energy issuers will find themselves struggling to service their debt. A best guess: Oil at $35 per barrel could entail not only a significant widening of spreads for energy issuers but potential contagion to the rest of the asset class.

This is important. One factor that has kept markets aloft year-to-date has been well behaved credit markets. As experienced in early 2016, credit contagion could derail equities as well. The good news today is that the pain point, i.e. when high yield succumbs to lower oil, is a good deal lower than it was. This provides some cushion for both credit and equity markets.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.   ©2017 BlackRock, Inc. All rights reserved.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Drilling Down for Bargains After Oil’s Decline

Oil Rig

Stocks have suffered lately, with year-to-date returns for U.S. equities once again negative. The most recent driver of the sell-off, and accompanying volatility, hasn’t been fears of a Federal Reserve (Fed) rate hike, but rather collapsing oil prices and the implications for energy-related debt.

Paying less at the pump might seem like a good thing for consumers, but the recent drop in crude prices has reinforced fears over slow economic growth and deflation, placing pressure on a range of asset classes related to energy.

According to Bloomberg data, amid concerns over energy issuers in the high yield market, high-yield spreads continued to widen last week. The fall in oil is also putting more pressure on already battered emerging market oil-exporting currencies, including those of Mexico, Russia and Columbia. Finally, and not surprisingly, any company in the energy space is feeling pressure. This includes not only oil production and service stocks, but also Master Limited Partnerships (MLPs).

However, while market sentiment has certainly turned more negative lately, many investors are wondering if it’s time to start bottom fishing, especially with regards to beaten-up energy assets.

Considerations for Energy Sector Stocks

My take: Though I would remain cautious toward the commodity and believe energy-related names are likely to come under more short-term pressure, I do see longer-term opportunities for those with little or no exposure to energy stocks.

The near-term risk for investors is that, regardless of the particulars of the business model, any stock even tangentially related to oil or energy is being thrashed. This is likely to continue to the extent oil prices have more downside. In fact, given the abundance of supply and bulging inventories, I’d be hesitant to call a bottom in oil prices.

While I believe that oil supply and demand will start to balance toward the middle of next year, absent a supply disruption from the Middle East or a much sharper deceleration in U.S. production, the simple truth is that there’s still too much oil supply relative to demand.

The outlook for Middle East supply remains undimmed, despite growing geopolitical risks. The Organization of the Petroleum Exporting Countries (OPEC) is unable to even set a production target, and Saudi Arabia and Iraq are producing record amounts of oil. Even a country like Libya, with no functioning national government, has dramatically increased production in recent months.

Making matters worse, non-OPEC oil production has remained resilient. In an attempt to generate much needed revenue, Russia is pumping a record amount of oil. In the U.S., while production has pulled back from the spring peak, production cuts have been modest thanks to improving efficiency. The number of U.S. rigs is down more than 60 percent from its 2014 peak, but U.S. domestic production is off by less than 5 percent, according to data accessible via Bloomberg.

Nor is a surge in demand likely to quickly rescue oil markets. For 2016, global demand growth is estimated to fall to 1.2 million barrels per day (bpd) from 1.8 million bpd this year, as data via Bloomberg show. It will take time to balance out oil markets, assuming we don’t see a more meaningful disruption in supply or a spike in demand, which is unlikely given the sluggish pace of global growth.

However, while an imminent V-shaped recovery in physical oil looks unlikely, some of the stocks in this sector may still represent a good long-term opportunity, especially considering that energy-sector valuations are now the cheapest we’ve seen in decades, according to data accessible via Bloomberg. There are two places in particular investors underweight the energy sector may want to start looking to add positions: U.S. drillers levered to low cost production sites and midstream MLPs.

1. U.S. DRILLERS LEVERED TO LOW COST PRODUCTION SITES

The cratering in oil prices is hurting any and all energy companies, but I believe those with lower production costs, such as Exploration & Production companies focused in the Permian Basin in west Texas, are better positioned to ride out a period of depressed oil prices.

2. MIDSTREAM MLPS

While MLPs aren’t immune to the energy market, as evidenced by the recent 75 percent dividend cut by Kinder Morgan, many MLP businesses are focused on natural gas storage and pipelines. These midstream businesses are less exposed to the daily fluctuation in oil prices.

The bottom line: While the energy sector comes with considerable near-term downside, the key for the long term is selectivity and a focus on those names best positioned to survive, or even thrive, in what may be a prolonged period of low energy prices.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2015 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

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How Long Will the Energy Sector’s Struggles Last?

Energy Sector Performance

One of the largest upheavals in financial markets during the past year has been the plunge in the price of oil. The price of West Texas Intermediate crude oil (one of the main gauges of “the oil price”) has fallen from over $100 per barrel in July 2014 to around $45 per barrel. This decline has decimated the energy sector, which has lost almost 30% of its value over the past year while the overall US stock market has gained more than 10%. Is the energy sector’s underperformance a short-term aberration or part of a longer-term trend?

Part of that answer depends on the outlook for the oil price. After rallying a bit this spring, the oil price resumed its descent in July. The prospect of increased Iranian oil production following the country’s nuclear deal with the US and other countries, high levels of global oil production, and worries about a potential slowdown in China’s economy all likely contributed to the fall. Each of these factors could persist for a while, so the oil price may not bounce back any time soon.

Another part of that answer depends on whether energy companies can adapt to lower oil prices by reducing their costs, for example by decreasing the size of their workforces and investing less in new exploration. By some estimates there have been almost 200,000 layoffs in the global oil industry since the middle of last year. The lower supply resulting from these changes could help the oil price arrest its decline and at least partially restore energy companies’ profits.

But low oil prices probably don’t explain all of the losses for energy stocks. In fact, the sector’s 40% underperformance compared to the broader stock market during the past year is far more extreme than during other recent oil price declines, even the 70% collapse in the oil price during the second half of 2008. It’s therefore likely that longer-term factors have contributed to the sector’s recent struggles as well.

Two such factors that have accelerated recently are the rise of alternative sources of energy and more stringent environmental regulations. These may be more difficult for energy companies to adapt to than a changing oil price, and they could continue to be a drag on energy stocks even when the oil price rebounds.