As we have discussed in our recent writings, we have been strategically allocated to the energy sector in our portfolios and, as such, have been hit by the decline in energy prices, as well as general high yield market contagion, with the meltdown in energy exploration and production (E&P) credits spreading to the overall high yield and loan markets. We believe that in today’s broader high yield market we are now seeing a disconnect between fundamentals and pricing and that disconnect has created what we see as an attractive entry point into the high yield asset class.
We have been and continue to be strategically positioned in the oil and gas industry, and that positioning has and continues to be very intentional. While oil prices have fallen below $60 per barrel for the time being, we believe prices below $80 are unsustainable and have provided chapter and verse as to why (see our piece, “Rome Is Burning”). Simply put, costs of unconventional oil (where the production growth actually is) are high and returns must be there for production to continue. This includes certain tight oil plays (i.e., US shale producers), along with deepwater and oilsands. There is limited growth in production globally outside of these areas. The Saudis know this and will keep the heat on.
We believe that the law of unintended consequences may ultimately lead to a collapse in production not only from the US, but Venezuela, Libya and Nigeria as well. For instance, just last week, Libya announced that infighting within the country causing the closure of two of the largest ports has led to a significant decline in production. The world is not as well supplied as many believe. Thus we would foresee that as production/supply takes a hit, this could lead to a dramatic rebound in oil prices on a supply/demand imbalance, as we continue to see growing global oil demand needs.
Turning to the US, domestic shale producers who are levered are experiencing bond price declines in some cases of up to 30-50% over the past couple months. We are not invested in these US shale producers, as we believe that defaults will be real and recoveries may be minimal for many investors. Many of these “businesses” have huge decline rates, we’ve seen reports that in some cases they can even be upwards of 70% per year; thus we would view them more akin to “projects” than real, sustainable businesses. Even prior to the oil price decline, it was our opinion that these basins will be drilled out and start declining in the next few years, and with current price points we would expect decline that may well accelerate.
These huge decline rates in shale matter because it means that large capital spending, and equity and debt financing to fund that spending, is required to keep production steady at best in many cases. While other players in the space, such as the oilsands producers up in Canada, have the ability to meaningfully cut back on capital expenditures and conserve cash during these periods of low oil prices, without taking a massive hit on the product front, we don’t see this same ability with many shale producers, which can quickly lead to a downward spiral for both the bonds and equities in these companies.
We have very specific energy themes, such as focusing on Canadian producers, service providers, and midstream companies, and have been very intentional as to what we hold and why we hold it. Looking at the general high yield space, at over 16% of the high yield index, energy is the single biggest industry by a factor of two (healthcare is just over 8% of the high yield index)1 and must be dealt with by income-focused investors whether that is through high yield markets or MLPs (master limited partnerships), which also tend to have large exposure to energy. Investors need to understand what is underneath the energy exposure they do have.
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