“In the short term, the market is a popularity contest; in the long term, it is a weighing machine.” Benjamin Graham
With oil prices now back to levels consistent with stress but not widespread catastrophe for related engineers, explorers and producers, we believe there is value within energy-related fixed income investments. But investors have to be discerning when lending to the sector. We see this market as an opportunity for active managers to distinguish between value traps and value opportunities.
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Saying commodities were out of favour with investors at the beginning of this year would be an understatement. In terms of a popularity contest the only certainty was that oil, and more or less any company or institution associated with oil, were losers. However, oil prices have since recovered from their lows and, at the time of writing, the price of a barrel of oil is around $50. Now that the market appears to be in more of a ‘weighing machine’ mode, should investors think about buying energy-related bonds and, if so, what particular areas of the bond markets look interesting?
The answer depends on a variety of factors. Oil prices primarily fell because of excess capacity, rather than a lack of demand. Very simply, high oil prices rendered previously unprofitable methods of extraction viable, helping to create a significantly oversupplied market amidst fairly consistent demand trends.
Oil prices, rather than easing gently, plummeted like a stone (Figure 1) - what should have been a tailwind for the economy turned into a headwind, with the sharp rate of change in oil prices helping to decimate large chunks of the energy sector and associated industries.
Finding the breakeven
The key to analysing the oil sector is determining what the breakeven oil price is, i.e. when the price of a barrel of oil exceeds the cost of production. Barclays Research suggests that only one third of high yield exploration and production (E&P) companies have a breakeven price of less than $60 per barrel of oil, and that the average breakeven cost is closer to $70 including development costs.
Of course, averages hide a much wider range and cost curves are notoriously hard to pin down in any case, particularly in the context of the dramatic contribution from technological improvements over the last several years. The reality is that there are few shortcuts. Specialist knowledge of the individual companies and sub-sectors is a prerequisite to successfully cherry picking the right investments.
The importance of leverage and cash flows
In a world where lower oil prices could conceivably linger, companies with lower leverage, strong liquidity and free cash flow, as well as easily disposable assets will be at an advantage. Liquidity is paramount as it gives the company breathing space to perform the necessary remedies ranging from the relatively painless capital expenditure cutbacks to more strenuous restructuring. Careful analysis of the company’s debt structure and covenants is also required as falling revenues will result in higher leverage and lower interest coverage, both of which may breach loan cove ants thus creating further distress.
Determining the quality of the companies’ assets requires a forensic approach in analyzing oil resources between non-proved and proved reserves, and of the proved reserves the differences between the undeveloped and developed resources potentially on an oil well by oil well basis. Here the message is that for proper analysis significant resource and expertise are required.
Companies that have exposures to geographies where the cost of production is high, such as oil sands, deepwater, or in the arctic, will be at a disadvantage. However, modern assets such as the latest generation of drilling and production rigs will be more efficient and help offset this (Figure 3). Other aspects to consider include the tax revenues charged by the jurisdiction in which the entity is located, the region’s political stability, as well as the level of infrastructure development.
Diversified opportunities or national champions?
As with all aspects of investing diversification is the only free lunch. The obvious candidates are the so called ‘supermajors’. These are the world’s biggest oil companies. Biggest is not always best, but they are well diversified across geographies, technologies and businesses. Just as their production arms suffer when the oil price falls so other parts such as trading and refining will benefit. They mostly also benefit from strong balance sheets and good financial health and tend to be best placed to survive periods of depressed oil prices. Another obvious area to look at is the US junk bond or high yield market (Figure 4), as around 13% of the issuers are oil-related energy companies. So, when thinking of diversification, should the investor gain exposure through an active manager or passively through an ETF? Active managers have the potential to determine the better run companies over the medium term through careful analysis. Thus, they can avoid the inevitable defaults that have occurred, and which are almost certain to happen over the coming months, as oil companies face a wall of maturing bonds in 2017 and 2018 which will need to be refinanced.
National oil companies (NOCs) are also worth considering, especially for the more adventurous investor with a high risk appetite. NOCs are entities where the relevant government either wholly owns, or has a significant share in the company’s share capital and provides implicit, or even explicit, support for the entity, buttressing it during stressful times. They also provide a good paradigm of the oil industry as a whole as, while some of these companies are at the centre of a national scandal, such as Brazil’s Petrobras or Venezuela’s PDVSA, not all of them are.