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Fixed-Income Insights

Amid the rubble, there are a number of compelling total-return opportunities in the high-yield energy sector that are trading at stressed valuations.

The year 2015 was a challenging one for the high-yield bond market, and throughout there was a very consistent theme: a troubled energy sector that declined more than 23% in the year. Metals and mining credits were just as dismal, with a decline of more than 25%; but the energy sector weighed much more heavily on the high-yield market given its significant weighting in the BofA Merrill Lynch U.S. High Yield Constrained Index (HY Constrained Index). Believe it or not, in May 2015, the high-yield energy sector (as represented by the HY Constrained Index) was up 7% for the year, as many opportunistic investors dove into the sector after a late-2014 swoon. Those that chased this performance, however, were not rewarded, since the sector declined more than 28% during the last seven months of 2015.

Thanks to this underperformance, the energy sector now accounts for only 10% of the HY Constrained Index, down from a peak of 15–16% in mid-2014. While its weighting in that index is smaller, the energy sector is still a significant portion of the high-yield market, and continues to dominate our discussions as an investment team and in our communications with our clients. In addition, the sector soon may be growing again, as fallen angels (that is, bonds that were investment grade and fell to junk status) fall from the investment-grade market into the high-yield indexes. By our estimates, $75–125 billion in energy paper may drop into the high-yield market over the next 12 months.

In this report, we will freshen up our macro thoughts on the supply/demand equation and the impact of investment-grade credits dropping into the HY Constrained Index. We also will examine valuations and discuss our current thoughts on positioning within the various subsectors of the energy sector. The sector will remain volatile, but the volatility also is creating a number of compelling investment opportunities that we will seek to capitalize on this year.

Macro—The Supply/Demand Equation
By now, most investors know how we got to this point in the global energy markets. It would have been impossible to think so 10–15 years ago, but the United States is now the swing producer in the global oil markets. Innovations in fracking technology and capital provided by yield-hungry high-yield investors led to a boom in U.S. energy production, with a 1.2 million barrel-per-day (bpd) increase in production in North America in 2014. During this period, supply in the rest of the world held constant. Global demand also grew during this time frame, but we are still left with a surplus of approximately 1.5-1.75 million bpd, according to the International Energy Agency.

 

Chart 1. Demand Must Catch Up to Supply

Sources: IEA, JODI, HPDI, EIA, Rystad, WoodMac, Morgan Stanley Equity Research, and Morgan Stanley Commodity Research forecasts.

 

So, we now are left with the question of how this gap will be closed. While approximately 1,200 rigs were taken offline in the United States over the last year or so, according to the International Energy Agency, production remained stubbornly high, thanks to the remaining wells becoming more productive. Based upon what we have been hearing on fourth quarter 2015 earnings calls, energy companies are taking even more drastic measures to cut capital expenditures and curtail production. The impending defaults of many high-cost operators also will take a nominal amount of capacity offline in the United States. However, there are many other moving parts to account for.

Just recently, Saudi Arabia’s oil minister disclosed that the country was attempting to broker a deal among the Organization of the Petroleum Exporting Countries (OPEC) and non-OPEC oil-producing countries to freeze production at January 2016 levels in order to support prices. Overall, nothing material should be taken from this announcement, although it is positive that a surprise meeting, which included two of the three largest producers in the world, even took place. Some of the decline in U.S. supply may be offset by supply coming online from Iran, which is planning to increase output by 500,000 bpd, according to Bloomberg, now that sanctions have been lifted.

Going into this year, many expected global demand to increase by approximately 1.2–1.5 million bpd to help close the supply demand imbalance. However, renewed concerns about global growth have caused markets to question these assumptions.

We would argue that the 2016 leg of the energy sell-off is more about demand-related concerns, as opposed to the supply-related fears we have seen since mid-2014. Inventories currently are quite high, and remain a key data point for investors tracking the space, as any meaningful drawdown could lead to a sharp turn in sentiment, given how negative the consensus view in the energy patch is right now. Given that a global recession is not our base case, we could see the market move toward a more balance supply/demand picture in late 2016 or early 2017.

Energy Sector Is Likely to Grow Again—Thanks to a Rise in Fallen Angels
After five years of improving credit conditions, credit fundamentals took a turn for the worse in 2015, with the number of credits dropping from the investment-grade market to high yield outnumbering those that graduated from the HY Constrained Index. As you would imagine, the bulk of the downgrades came from the energy and metals and mining sectors. Based upon our expectations, this will be a continuing challenge for investors in the high-yield market in 2016. After analyzing the investment-grade energy sector, we find that there could be somewhere in the range of $75–125 billion of investment-grade energy bonds dropping into the HY Constrained Index over the next 12 months. If all those credits were to dip into the high-yield market, it would increase the energy sector’s weighting in the index back up to near 15%, by our estimates. While this does leave a technical headwind, it also can create opportunities. For example, when an investment- grade exploration and production company was downgraded from ‘BBB-’ to ‘BB+’ this year, the company’s bonds were trading near 60 cents on the dollar. This will be a continued area of focus for us, as history has shown that most of the performance in such firms is taken in credits leading up to their downgrade. Quite often they will outperform the market after dropping into the high-yield index. Our credit analysts cover the full ratings spectrum, which we believe leaves us well prepared to capitalize on this opportunity set.

 

Chart 2. Fallen Angels Outnumbered Rising Stars in 2015
U.S. high-yield rising stars versus fallen angels (as of February 12, 2016)



Source: JP Morgan. 
“Fallen angels” are bonds that were investment grade and fell to junk status. “Rising stars” are junk bonds with credit ratings that have been improving.

 

Energy Valuations—Discounts Everywhere
As of February 5, 2016, there was more than $200 billion in the face value of bonds in the BofA Merrill Lynch High Yield Energy Index (HY Energy Index). However, given the decline in recent valuations, those bonds account for approximately only $115 billion on a market-value basis. We are often asked how much default risk is “priced in” to the market. When we examine Chart 3, we can see that $73 billion, or almost 40%, of the face amount of bonds in the energy sector is trading below 50 cents on the dollar. Virtually all of the debt in HY Constrained Index is trading at a discount to par. While we never want to say “it can’t get any worse,” we can state that a tremendous amount of pain has been factored into the sector. Amid the rubble, there are a number of compelling total-return opportunities trading at stressed valuations.

 

Chart 3. Energy Bonds Are in the Discount Aisle
Total face and market value by price of bond as of February 5, 2016


Source: Lord Abbett and BofA Merrill Lynch. 

 

Current Approach to Energy Sector
To be sure, navigating the high-yield energy landscape remains incredibly challenging, and will remain so for much of 2016. While our defensive approach toward the sector has served us well over the last several quarters, we are looking at the energy sector opportunistically. Below, we discuss our views on some of the subsectors within the energy market:

  • Pipelines/gas distribution—While this area of the market does have defensive characteristics, many investors have learned over the past year that it is not as defensive as they may have thought. While most have contracts that set the price on energy products that flow though their pipelines, earnings can be negatively affected by declines in volumes. With many exploration and production companies within the United States cutting back on volumes, the profitability of many pipeline issuers is declining. This sector of the market also has the most significant technical overhang, with more than $70 billion in bonds that could be downgraded from the investment-grade market.
  • Exploration and production (E&P)This is the segment that presents the most opportunities, in our view. Throughout the last year and half, we have focused our E&P exposure on well-managed energy companies with top-tier assets in areas that are in West Texas and New Mexico, such as the Permian Basin. We also consistently have avoided companies with lower-tier assets that need a price north of $60–70 per barrel in order to be profitable, such as those that reside in the Bakken Basin around North Dakota and Montana. The most fertile hunting ground lies in the mid-tier assets, which reside in the Eagle Ford (south Texas) and Niobrara (Colorado) regions of the country for oil and the Marcellus (eastern U.S.) region for natural gas. Within this tier of assets, we are looking for well-managed companies at stressed valuations wherein we can see a liquidity runway that will take the company at least into the later part of 2017. We have found compelling risk/reward opportunities in this sub-sector.
  • Oil field servicesOil field services are the worst place to be on the energy food chain, especially since companies are cutting back on production and closing rigs. This portion of the energy sector has been hammered over the last year and a half. However, there are a number of services companies on our fallen angels’ screen, which may present attractive total-return opportunities later this year.

Conclusion
As investors debate the strength of the global economy and the impact of divergent monetary policies, the markets may remain volatile in 2016. Energy, of course, will be at the forefront of this volatility. However, market dislocations create opportunities. Our defensive posture toward the energy sector over the last year and half now places us in a position to search for compelling total-return opportunities for the benefits of our high-yield strategies and investors.

 

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