- Crude oil markets have experienced unprecedented volatility.
- The capital market’s response has been swift and severe.
- A broad contraction of global energy activity is expected.
- Short-term oil price volatility should give way to longer term stability at higher price levels.
- Patient, longer term investors will likely be rewarded.
In the past month, crude oil prices have fallen rapidly to levels not seen in more than two years, sounding alarm bells among investors. In this paper, we address our view on how the oil market arrived at this position, the dynamics under current and future consideration, and how Western Asset, as longer-term value investors, looks to position portfolios to take advantage of capital market dislocation.
At the heart of our ongoing analyses is an understanding that current oil prices are generally not an accurate predictor of future oil prices, as is evident in Exhibit 1. Rather, we believe a close examination of supply and demand fundamentals offers the best indication of the direction of long-term oil prices.
The energy industry is a highly cyclical one that can result in vicious price corrections, short-term volatility at lower levels and broad industry contractions, typically giving way to medium- to longer-term price stabilization at higher levels as growth in global oil demand resumes. Over the years, we have experienced many such cycles and expect the industry response to the current one to be consistent with prior actions. However, it is important to acknowledge some key differences with this cycle. Because the current oil supply/demand balance is consistent with previous cycles, we do not consider the oversupply as being particularly problematic—though a supply response is necessary to prevent the imbalance from widening further. Demand, while still growing positively, is expanding at a slower rate and is therefore less likely to help balance the market over the short term. Longer term, the key variable for oil demand remains global economic growth. Before we look at potential outcomes, it is important to understand the factors that are currently at work in the market.
How Did We Get Here?
The drop in oil prices is the result of a confluence of events, but oversupply is the primary reason. For several years now, US supplies have grown rapidly as technological developments have made it possible to extract shale oil from previously inaccessible tight rock, opening up a new domestic source of energy for US-based companies and consumers. Furthermore, these advances in drilling technology have allowed for greater efficiencies in the production process, resulting in accelerated production timelines. These industry advances have been facilitated by easier access to both debt and equity capital, enabling rapid expansion of total US production over the last five years.
While North American oil production has grown significantly, non-OPEC oil production has remained relatively stable. And, despite unrest throughout the Middle East, North Africa and Russia, production volumes have remained resilient. In direct response to the rapid fall in oil prices since July, it is our understanding that some OPEC and non-OPEC producers, led by Saudi Arabia, had convened ahead of the November OPEC Ordinary meeting in an attempt to garner support for a coordinated output cut. Unable to reach an agreement, market forces were allowed to function, resulting in further downward price pressure. In addition, Saudi Arabia cut official selling prices for the country’s oil, a move perceived by the market as an attempt to increase market share rather than supporting prices by managing production—a role they historically have played.
While oversupply laid the foundation for weaker oil prices, the International Monetary Fund (IMF) and the Federal Reserve’s (Fed’s) lowered expectations for global growth, and hence lower oil demand, further accelerated crude oil’s price decline. In addition, economic data out of Europe, underscored by a disappointing GDP reading from Germany, caused additional concern over near-term crude oil demand. China, another large oil consumer and the main source of demand growth, is also showing signs of reduced economic activity as it shifts from an investment- and export-led growth model to a more sustainable consumption- and service-based model. In addition to global economic growth concerns, global refinery demand has been at seasonal lows given a heavy maintenance and product turnaround period. We believe these pressures are temporary, as the European Central Bank has taken a more accommodative stance to support the ongoing recovery in Europe, Chinese authorities have signaled their willingness to manage the slowdown with a more accommodative policy, if needed, and refinery demand should improve next spring.
The cumulative result of disruptions to the supply/demand equation has been an estimated market imbalance of between 1.0 million barrels per day (MMBpd) and 1.5 MMBpd , as shown in Exhibit 2. This is comparable to prior cycles, and considering that daily global oil demand amounts to 93 MMBpd and is marginally growing, the imbalance is not insurmountable in our view. However, supply growth must be contained for balance to be restored.
Outside of direct supply/demand dynamics, changes in investor sentiment have also contributed to oil’s price decline. After months of unrest across major oil-producing regions, geopolitical risk premiums have generally subsided, greatly diminishing concerns of what would happen to supply if turmoil forced production in one of the major oil producers to halt. In addition, producer hedging (at higher levels) led affected counterparties to sell down oil exposures into a weakening market to limit the position losses, particularly as prices penetrated the level at which the hedge was struck. Furthermore, dollar strength, driven by continued strong US relative economic performance, added further pressure to oil prices.
In the capital markets, market technicals have played an important role in the volatility we’ve witnessed in security prices. Recent months have been marked by seasonally lower dealer activity, reducing liquidity and heightening market turbulence, causing an increase in price dislocations throughout the investment-grade, high-yield and emerging markets (EMs) sectors, which have all been heavy issuers of energy-related debt over the past several years. Within the high-yield market, significant investor redemptions have exacerbated an already fragile market. Price pressures and further selling fed on themselves, pushing prices materially lower, resulting in a re-pricing of high-yield energy to relative spread levels never before witnessed, as shown in Exhibit 3.
Stabilization Expected Over the Long Term
We believe US oil producers will exhibit a swift and rational response to lower commodity prices, opting to aggressively rein in near-term capital expenditures, which should have a positive impact on the current supply/demand imbalance over the course of 2015. While current supply/demand fundamentals are weak, we believe the challenges are largely transitory and can be addressed through restricted supply and stronger demand in the long term.
Upside risks include the possibility that US production cuts are extremely deep and swift, effectively neutralizing the imbalance. Similarly, we would not rule out a special OPEC meeting should prices move materially lower. Meanwhile, geopolitical risk could return; whether from civil unrest or upcoming elections, the threat of supply disruptions among producers such as Iraq, Libya and Nigeria remains very real. In such situations, supply can come off the market quickly and have an immediate impact on oil prices. The current lack of OPEC spare capacity would only exacerbate the situation. Meanwhile, increased sanctions on Russia could limit near-term supply as well as longer term supply growth. On the demand side, a stronger-than-expected economic recovery could meaningfully increase many countries’ energy demands. In China, more accommodative economic policy could strengthen growth, thereby increasing the country’s energy needs. Although the Chinese New Year may dampen demand in the short term, a successful transition to a more sustainable growth model would increase China’s long-run per capita demand for oil.
On the other hand, weaker-than-expected global economic activity would reduce demand, worsening current imbalances. OPEC could also delay coordinated production cuts, worsening oversupply. With Iran sanctions currently under review, there is also a possibility that a potential lifting of restrictions would bring more supply to the market. Additionally, sustained or increasingly negative investor sentiment could also take its toll on the market, particularly as we enter a seasonally slow demand period for oil. Should any of these risks materialize, we could observe oil prices moving substantially lower, possibly toward cash costs of production, which we believe are below current oil prices.
Implications for Investors
In the short term, energy market fundamentals, in our view, will remain challenged. Prices can overshoot to the downside as the market searches for a bottom. However, we believe this volatility creates opportunities for investors. Consistent with prior cycles, we expect US energy producers to rationally cut capital spending budgets to reflect lower future cash flow expectations and lower reinvestment economics, instead focusing on liquidity and capital preservation. In addition, energy companies will likely use market dislocations to reposition asset bases for the long term, opening the door to increased M&A activity. As companies focus on preserving liquidity and strengthening balance sheets, investors have an opportunity to capitalize on dislocations in security valuations. Although production growth will likely still occur—albeit at a slower pace—lower service cost inflation will follow at a lag. With oil at such low price levels, new projects are unlikely to get approved, thereby removing sources of future supply. We believe rational behavior will return in this new price reality; the longer prices stay low, the more aggressive the producer response will likely be.
We anticipate the global economy will continue moving forward at a slow-but-steady pace, helped by continued Central Bank accommodative policy measures. Longer term, our expectation is for oil demand to continue to rise, largely as a result of growth in emerging and developing economies. While we believe oil prices will move higher over the next two years, a return to triple-digits is unlikely due to Saudi market share orientation and US shale productive capacity, unless significant underinvestment by the industry occurs (as has happened in the past).
Energy is a deeply cyclical sector. At Western Asset, we are well-accustomed to fluctuations in the market and have always employed a patient, long-term value approach. Our fundamental focus on supply/demand allows us to maintain and capitalize on temporary bouts of volatility. We believe the most attractive opportunity set currently lies within the high-yield energy market, which has experienced rapid and violent re-pricing on an absolute and relative basis. However, investment-grade markets cannot be ignored as the weakness allows the portfolio quality to be improved at cheaper security valuations. We recognize that supply/demand fundamentals remain challenged, but believe current valuations offer compelling above-market total returns in select parts of the energy credit market.