Download Implications of Energy Price Weakness

Implications of
Energy Price Weakness
PAOLO R. FRATTAROLI
RESEARCH ANALYST, THE RACHLIN
GROUP
Oil price declines have roiled the capital markets over the past month, prompting questions
regarding the fate of energy companies, their implications for global growth and the
trajectory of financial assets. Several Neuberger Berman portfolio managers and analysts
recently compared notes on market conditions and their impact on investment decisions.
They generally agreed that the current supply/demand imbalance could have significant
implications for security selection in the energy sector, but also noted the broadly supportive
effect that cheap oil could have on consumption, and the potential investment opportunities
that may emerge as a result of recent developments.
JAMES GARTLAND
PORTFOLIO MANAGER, TEAM KAMINSKY
SOURCES OF THE DECLINE
MATTHEW L. RUBIN
DIRECTOR OF INVESTMENT STRATEGY
VIVEK BOMMI, CFA, CPA
DIRECTOR OF NON-INVESTMENT GRADE
CREDIT RESEARCH
For much of the past three years, oil prices were generally in the $100 range, but have
dropped more than 40% since midyear. This is largely due to expectations for slowing
global growth and unanticipated additional supply. Economic news in China and Europe
prompted the International Energy Agency (IEA), the key industry monitor, to cut its
projection for 2014 worldwide demand growth from 1.3 million barrels a day at the start
TODD HELTMAN
SENIOR ENERGY ANALYST, GLOBAL
of the year to the current 700,000 barrels—nearly a 50% reduction. On the supply side,
EQUITY RESEARCH
the ramp-up of Libyan production (by more than 500,000 barrels a day) over the summer
was a surprising negative for market fundamentals. With oil prices already depressed, on
GORKY URQUIETA
CO-HEAD, EMERGING MARKETS DEBT
November 27, OPEC announced its intention to maintain current quotas, leaving it to
others to restore balance to the energy market. This triggered a further, rapid slide in oil,
DECEMBER 2014
worsened by a reduction in IEA demand growth expectations for 2015 from 1.1 million to
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the wake of these developments.
RICHARD J. GLASEBROOK, II, CFA
PORTFOLIO MANAGER, THE STRAUS
GROUP
WHAT’S NEXT?
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OPEC’s announcement, according to the Neuberger Berman experts, is both an effort to
bring non-compliant OPEC members into line and, significantly, to put pressure on North
American shale companies—which have accounted for nearly all the world’s incremental
supply growth in oil over the past several years. The tactic appears to be on target,
observed Todd Heltman, senior energy analyst for the Global Equity Research team.
With oil prices at these low levels, shale simply “does not work” given typical marginal
production cost of $80 – $90 (over a full cycle), and producers are already adjusting their
capital expenditure budgets. Announcements regarding reduced drilling are coming
in steadily, though the extent of the cutbacks won’t be known until late January, when
companies release their regular reports. He noted that there is potential for the marginal
cost of shale to decline given that oil service costs are expected to fall 10% – 20% in 2015.
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IMPLICATIONS OF ENERGY PRICE WEAKNESS
Unfortunately for commodity prices, there is a significant lag (often 6 – 9 months)
between reductions in capex budgets and their impact on production. Heltman believes
it could take up to two years for the market to reach equilibrium. This timetable could
be accelerated if demand rebounds due to lower prices or if shale companies—the
world’s most price-sensitive producers—are able to adjust output faster than expected,
particularly given uncertainty around the productivity decline rates of unconventional
energy wells. While prices are expected to be near current levels through the first part
of 2015, a rebound seems likely as production from the U.S. begins to slow. Richard J.
Glasebrook, II, CFA, portfolio manager for the Straus Group, thinks that oil prices are
close to a trough, and could rise over the coming quarters should supply growth wane
and demand (despite recent deceleration) continue to increase.
IMPACT ON ENERGY COMPANIES
In the meantime, weak prices are likely to have a major impact on energy company
profits and, more importantly, cash flows, which should become more apparent starting
after the fourth quarter of this year, noted Glasebrook. In addition to cutbacks, many
exploration and production companies will likely emphasize drilling in their more
productive areas to generate more cash flows per dollar spent. This high-grading of
acreage also has the potential to lower the cost curve of shale to some degree. Also, as
noted above, oil services companies are offering such companies cost breaks that could
somewhat soften the blow of lower prices (making margins more important than the
oil price itself). “Make no bones about it, though. The longer that low prices continue
that are below the full cycle development cost of shale, the bigger the impact,” observed
Glasebrook, with lower prices pushing companies with higher leverage toward debt
covenant limitations and potentially triggering consolidation and restructuring in the
energy space.
ATTENTION TO DEBT LEVELS
Still, Matthew L. Rubin, director of investment strategy, and the moderator of the
discussion, pointed out that a significant portion of energy companies are not highly
dependent on high yield debt and have managed their balance sheets effectively. Shale
companies have also tended to deploy capital back into the business at a greater rate
than in other industries, said James Gartland, a portfolio manager for Team Kaminsky.
However, even for some companies that have over-levered, debt terms and current
extended maturities could allow them to withstand low prices for several years. “It will
not feel good for the companies, and it won’t feel good for their bondholders at the time,
but they should be able to get through it.”
Vivek Bommi, CFA, CPA, Director of Non-Investment Grade Credit Research, noted
that, out of the U.S. high yield market’s 14% energy weighting, only 2.3% consists of
what he considers high risk/leverage names, based on an analysis of after-interest cost
structures and liquidity measures—reflecting the relatively conservative approach of
many companies. Still, he thinks that some companies that levered their balance sheets
to acquire properties at elevated valuations could face issues if prices remain low through
late 2016 or 2017.
ASSESSING ENERGY INVESTMENTS
Given the current challenging environment, the panel’s equity portfolio managers with
exposure to the energy sector have generally pulled back, particularly around the OPEC
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IMPLICATIONS OF ENERGY PRICE WEAKNESS
meeting on Thanksgiving, but are maintaining holdings in low-cost and high-quality
exploration and production (E&P) names, among others. “When you invest in E&P,
you want to focus on two attributes—companies with the ‘best rock,’ whether oil or
natural gas, that also have good balance sheets,” said Glasebrook. This, he believes,
generally allows such companies to get through downturns, benefit from problems
among competitors and even come out stronger.
Heltman agreed, noting that there are a number of E&P companies with such
characteristics that “could do just fine” at $80, $70 or even $60 a barrel. “Going
with the best, high-quality companies is probably more important than ever before.”
Elsewhere in energy, he believes that oil service companies remain challenged as E&P
spending cuts could lead to lower topline growth as well as price concessions that could
narrow margins. In the interim, large-cap E&Ps and integrated oil companies have been
relative outperformers.
Given that the spread on the overall high yield debt market has widened dramatically in
recent weeks, Bommi said the Non-Investment Grade Fixed Income team is currently
very constructive on the asset class. “The market’s pricing implies that half of companies
in the U.S. high yield energy sector will go bankrupt within the next three years. While
there will likely be some defaults, we just don’t think that’s realistic.” Within the energy
sector itself, the team favors high-quality E&P companies with significant hedged
positions and/or high natural gas exposure, as well as midstream/distribution companies,
but is wary of oil services names.
MLPS: PAINTED WITH THE ENERGY BRUSH
A key area that has benefited from the North American shale boom is midstream
companies, which focus on the transport and storage of oil and natural gas. According
to Paolo Frattaroli, an analyst with The Rachlin Group, many such companies are
largely insulated from commodity price fluctuations, with earnings tied to fees on longterm contracts. This is reflected in the low long-term correlations of MLPs to oil prices.
However, in times of short-term stress, correlations have been quite high, as seen in the
recent sell-off in MLPs. “I would not anticipate a meaningful bounce-back in MLPs
until oil has stabilized,” Frattaroli said. Still, he believes that longer-term prospects are
attractive, particularly as investors begin to revisit the favorable fundamentals of the
group. Moreover, many names in the sector are oriented to the natural gas market, where
strong fundamentals remain largely intact.
EMD: SELL-OFF APPEARS OVERDONE
In the wake of the OPEC decision, what had been a narrow sell-off of energy names in
emerging markets debt (EMD) morphed into a full-blown rout of emerging markets.
“Thus far, the dynamic has been one-sided, hurting oil producers and oil consumers
alike, even though the latter should benefit from lower energy prices,” said Gorky
Urquieta, co-head of the EMD team. For example, in the currency market, the Turkish
lira and South African rand have both declined sharply versus the dollar despite the
positive terms-of-trade adjustment they are now experiencing. And although Russia has
faced severe pressures, Urquieta believes that spreads on its sovereign debt have widened
more than is justified given their low debt levels and extensive international reserves.
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IMPLICATIONS OF ENERGY PRICE WEAKNESS
BROADER IMPACT OF LOW-COST ENERGY
Beyond the impact on the energy sector, a key takeaway for Matthew Rubin is the
generally positive impact of low oil prices on the economy. U.S. consumer balance sheets,
for example, are in good shape already, agreed Glasebrook, and the sharp drop in oil
and gas prices translates into a substantial “tax cut” that could benefit spending and, by
extension, consumer-related stocks. Airlines and other industries with substantial energy
costs also clearly stand to benefit. Gartland concurred, noting that a $60 price for WTI
in 2016 could translate into another $150 billion in consumer spending or an additional
1% in U.S. GDP. Still, “you have to step back and ask yourself why we’re getting this tax
cut,” which is largely the softening of demand growth due to the slow global economy, he
said. And despite talk of “decoupling,” the U.S. could eventually be affected by weakness
elsewhere.
Beyond the general ideas of the need for caution in energy and potential growth benefits
to the broad economy, current energy weakness carries considerable uncertainties. The
portfolio managers and analysts agreed that an emphasis on research, and selectivity in the
energy space, as well as the overall markets, could be especially important moving
into 2015.
Neuberger Berman LLC
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New York, NY 10158-3698
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