Energy volatility catalysts
On Friday, March 6, OPEC and Russia failed to reach agreement on increasing or even extending existing production cuts. OPEC was proposing a further one million barrel/day cut with Russia and other non-OPEC countries contributing an additional 500,000 barrel a day cut. Russia's position was that US shale and higher cost producers should lower supply given demand weakness.
US sanctions on Russian energy companies may have contributed to their more aggressive stance, as well as the perceived vulnerability of US shale producers given their more limited access to funding and limited ability to further reduce costs. While Russia has higher production costs than Saudi Arabia, the price Russia needs to balance their budget is much lower, reflecting the weak ruble and the Saudi economy's heavy reliance on crude exports.
In response to the lack of agreement, over the weekend, Saudi Arabia released new official selling prices for their crude that were at discounts of $6 to $8 below current prices, driving oil prices down to the low $30/barrel range on Monday, March 9. This is essentially a move to oversupply the market and take market share away from peers, including Russia.
It is possible the Saudi move will lead to a production curtailment agreement, as neither country can thrive with prices this low. But several rounds of diplomacy and discussion leading up to the OPEC meeting last week were not successful. As a result, weak prices are likely to extend through this year. The effect on cash flow and the balance sheets of US shale and other producers will likely be severe and they will reduce spending in response. There will likely be a six-to-nine month lag between this that could meaningfully show up in production levels. As a result, global crude inventories will likely increase, contributing to price pressure.
All segments of the energy sector will likely be impacted, but most notably exploration and production (E&P). The oil field service sector will likely be affected by reduced industry capital spending, but many of these names already traded at stressed levels. Midstream companies could face challenges with higher counterparty risks from E&P customers and slower growth. We expect large integrated companies with solid balance sheets and low-cost profiles may be more resilient, but could still be challenged maintaining their high dividend levels.
Within the high yield market, energy accounts for a decent size of the market with approximately 10.9% in the Bloomberg Barclays US Corporate High Yield Index, as of March 9. In contrast, the Bloomberg Barclays US Aggregate includes approximately 2.2% of exposure in the energy sector.
Using the JP Morgan EMBI Global Diversified index, there is no exact definition for energy, but focusing on energy exporters, the index has approximately 38% energy related credits, with Mexico (4.6%), Saudi Arabia (3.5%), Qatar (3.4%) and Russia (3.4%) as the largest countries represented in the index. Additionally, there are several large and diversified economies that also produce oil, such as Mexico. Conversely, there are several credits that are large energy importers and typically benefit from the decline in energy-related costs. The estimated net energy exposure, therefore, is less than the 38% as previously noted. Not all countries are as heavily reliant on oil, and portions of the index benefit, so the direct energy sensitivity is generally lower than implied by the outright percent of the index.
Downgrade and default expectations
Energy is clearly in the middle of the cross-hairs as a demand shock is being met with a supply shock and causing drastic price movements. Downgrade and fallen angel risk increased as the Saudi Arabia/Russia spat will likely put pressure on the US energy sector. Our energy analysts are stress-testing their credits, but our default assumptions have increased. For reference, JP Morgan's base case scenario assumes crude oil returns to $40/barrel in the second half of 2020 which could lead to 24% cumulative default rate for the energy sector.
Within investment grade credit, the energy sector is already starting from a lower-rated position than it did in 2014. During the energy sell-off in 2015, Moody's downgraded a handful of names to below investment grade, while S&P and Fitch kept issuers at investment grade. A change in outlook from S&P or Fitch has the potential to increase the fallen angel amount. The length of time that oil prices stay depressed and the feasibility of investment grade companies to pull other levers, such as dividend/capex cuts, will be key determinates from the rating agencies. Valuations reflect some of this concern with spreads for BBB-rated energy bonds at multiples of other industrial BBB paper. While pipeline names are likely to be less stressed fundamentally, the risks to the sub-sector also remain.
While the markets grapple with finding a bottom, we continue to leverage our research team to look for attractive opportunities. However, in general, we have not changed our portfolio positioning materially at this time.
Within high yield, buying opportunities may arise based on the recent re-pricing. With over a third of the high yield energy sector trading at recovery value, it seems like the worst is getting priced into the market. We are monitoring sectors such as airlines, gaming, leisure, and lodging that may reflect higher near-term recession. While it is never easy to call the bottom, we seem to be reaching a level that is attractive to spread investors willing to bet the economy does not slip into a recession.
Within emerging markets, there are select energy-related credits that we feel offer attractive value, such as some of the lower indebted energy countries/companies, but given the prospect for continued concerns on the coronavirus and the likelihood that oil stays low for a medium time period, we prefer higher-quality energy importers. Energy importing countries in Latin America/Caribbean and Europe have seen spreads widen, and if growth resumes in the second half of 2020, these credits could offer better risk reward vs energy exporters at this stage of the cycle. Further widening in energy-sensitive credits is needed to warrant higher positioning.
We expect additional support is coming from global policy makers, with central banks in the US and Canada going first for the developed markets. However, monetary policy is, at best, going to help ensure financial conditions don't unduly tighten. The recovery curve, whether it's a "V", "U", "L" or "W", is impossible to predict with any degree of confidence at the moment given all of the unknowns around the coronavirus. The US and global economies have experienced plenty of events which were short-term negative in nature, only to see the subsequent quarter's GDP print recover nicely.
Overall, we continue to leverage our research team as a slower growth environment implies rating agencies are likely to continue to be diligent on downgrades. There are plenty of opportunities for policy makers to respond. Those responses, such as quantitative easing would likely support credit spreads, but perhaps not immediately. We continue to believe credit selection will be key given the uncertain near-term growth environment.
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