We are ardent believers that the recent decline in the price of oil is temporary given continued demand growth (which will likely only accelerate at lower prices) and our expectation that worldwide supply will decline at current prices; in short, we expect that the supply/demand balance will shift leading to higher pricing.
Much of the incremental worldwide supply growth that we have seen over the past several years has been tied to growth in U.S. production, predominantly the U.S. shale regions. Looking at these shale producers, we’ve seen reported decline rates upwards of 70% in the first year for many of these companies. For instance here’s a look at the legacy production of two major U.S. shale basins, Bakken and Eagle Ford, where we are not only seeing huge legacy declines, but current new production not keeping up with these declines.1
Capital had been readily flowing up until now to fund the treadmill of constant capital reinvestment needed to keep up production, but what happens when the capital inflow stalls and investors wake up to the fundamentals of the businesses? We expect these dynamics will not only lead to a decline in U.S. production, but may ultimately lead to a number of producers who won’t be able to weather the storm.
With a larger and larger portion of U.S. oil production coming from shale producers who have these far greater decline rates than conventional oil producers, the total U.S. production decline rate has now more than doubled in the last five years, putting it at all-time highs.2
This at a time when we are also seeing massive declines in rig counts.3
So together we believe this has large implications for U.S. production going forward. We will continue to see a record amount of production needing to be replaced over time due to these natural decline rates, all the while capital investment to replace this production will be stymied and rig counts, an indication of future production, have fallen off a cliff, leading to a meaningful drop in U.S. oil production.4
Where does that leave us? If much of the incremental supply growth worldwide has come from the U.S., but that U.S. production will be declining, then the supply and demand balance will see a shift and thus we would expect to see a rebound in oil prices. Though we caution investors this may well take several quarters to play out.
So at face value, this should mean that the energy sector is an attractive area to be positioned as we wait for that rebound—we may see some continued near-term volatility but in the longer-term, energy names are bound to go up, right? But not so fast. While we are long-term energy bulls, there were certainly be winners and losers as these dynamics play out.
As noted above, we have our concerns not only about the longevity of shale production, but to the viability of many of the companies themselves. First of all, many of these shale producers did not generate free cash flow at prices nearly twice what they are today. Oil and gas production is a capital intensive business, so with the severe decline rates and less capital now readily available to regain that production, as well as the lower prices received for what is produced, we expect this may well lead to the lack of funds available to service the debt loads of many of these companies. In sort, we expect these dynamics may lead to a spike in default rates. And it isn’t only the shale producers that we see as vulnerable, but also the oil and gas service companies that will be hit as rig counts and production declines.
What does this mean for the general high yield market and investing within the space? The overall energy sector comprises 16-18% of the high yield market5, depending on what index you use, making it the largest industry concentration in the high yield market. So investors in the broad high yield market and index-based mutual and exchange traded funds likely have notable exposure to the sub-segments we see as most vulnerable. The general high yield market has already taken a hit due to its energy exposure over the last couple of quarters, so we don’t expect a potential increase in shale or service-related defaults to lead to another leg down in the general high yield market; however we do expect it will cause pain to investors in these specific names and sub-segments.
So while we see shale producers and service providers as the losers as trends play out in the energy space, we do see other areas of opportunity to capitalize upon our expectations for a rise in energy prices. For instance, we see opportunity in many of the Canadian oil producers. Heavy oil from Canadian producers is in much shorter supply than light oil (which is produced by many shale basins) and is needed by certain refineries, and these Canadian producers have higher reserve lives and are more capital efficient (i.e., much lower decline rates). Furthermore we expect that Canadian producers will benefit from the spread compression versus WTI (West Texas Intermediate)—in other words, the price for the Canadian grade of oil, WCS (Western Canadian Select), versus U.S. oil prices, WTI, is narrowing. WCS has always been at a discount relative to WTI, but that discount has seen huge compression over the last couple years, going from as high as $42 to now under $10.6
This means Canadian producers are receiving a better relative price than the publicized WTI price would indicate. Furthermore, oil is priced in U.S. dollars but costs for Canadian producers are in C$, so these producers benefit on the profitability side from a decline in C$.
We do expect that energy prices will rise, but that this rise may not be quick enough for many inefficient shale producers and services companies, thus we could see a pick-up in defaults for many of these energy companies. Yet, certain other companies and sub-segments of the space will benefit at their expense, as there will be other companies that can weather the downturn and will profit from the rebound in prices on the other side. Investors need to focus on the fundamentals of the businesses in which they invest and understand what they own, and be cautious of some exposures they may have when investing in the broader high yield market via passive mutual or exchange traded funds, where fundamental analysis is not the focus in determining holdings. Again there will be winners and losers; there are opportunities to be had and companies to avoid.
1 Source: U.S. Energy Information Administration (May 2015).
2 Petrucci, Anthony, John Bereznicki, CFA, Dennis Fong, Sam Roach, CFA, Yassen Bogoev, CFA, Jeff Ebbern, Oliver Bailey, and Alexander Kohout, “Canadian Junior & Intermediate E&P,” Canaccord Genuity, May 25, 2015, p. 3. Data sources include Canaccord Genuity estimates, IHS, EIA, DOE, and Bloomberg.
3 Baker Hughes U.S. Rotary Rig Count, as of 5/22/15, data sourced from Bloomberg.
4 Petrucci, Anthony, John Bereznicki, CFA, Dennis Fong, Sam Roach, CFA, Yassen Bogoev, CFA, Jeff Ebbern, Oliver Bailey, and Alexander Kohout, “Canadian Junior & Intermediate E&P,” Canaccord Genuity, May 25, 2015, p. 3. Data sources include Canaccord Genuity estimates, IHS, EIA, DOE, and Bloomberg.
5 Energy is 17% of the JP Morgan USD US High Yield Index. Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 7.
6 For instance, over 16% for the JP Morgan US High Yield Index. Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American Credit Research, May 15, 2015, p. 48.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. Information on this website is for informational purposes only. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risk and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
This article was written by Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD).