10th March 2016
Global oil markets have rallied hard with the Brent crude benchmark breaking back through $40 earlier this week. From its 12-year low of just above $27 in late January, Brent has climbed more than 50%. Is this rally sustainable, or just a dead cat bounce? Four managers give their views below.
Andrew Jamison, high yield credit analyst at T. Rowe Price
With yields on high yield energy issues averaging almost 600 basis points higher than the broad market at the end of 2015, much bad news clearly has been built into valuations. At some point, this yield pickup will become too attractive for high yield investors to ignore, especially as the sector is cleansed of weaker credits and absorbs relatively high-quality issuers to have fallen out of the investment grade market. That time, however, has not yet arrived, in our view. With credit fundamentals still deteriorating, and liquidity conditions fragile at best, caution is warranted. We expect 2016 to be a year of volatility and bottom testing, offering select bargains, but also considerable risks.
However, if oil prices do fall far enough to shut off excess supply, energy issues could prove an interesting place to invest in 2017. Oil and gas producers – leveraged both to any rebound in prices and to continued cost reductions and productivity gains – appear best positioned to benefit. But in-depth credit analysis will remain critical to identifying excess return opportunities and to managing risk. #
Fraser Lundie, Co-head of Credit at Hermes Investment Management
The correlation between commodities, particularly oil, and US high yield is likely to remain high, given that the loss of names from the indexes via defaults is being more than offset by ‘fallen angel’ supply from Investment Grade. The high yield market reaction to any improvement in commodity outlook is amplified by the light positioning in affected sectors mirroring the poor sentiment in the space. We remain constructive on higher quality US high yield, in particular areas such as basic industry, autos and auto parts, where opportunities have presented themselves in solid, improving credits sold off in sympathy with oil.
Indeed for some, lower oil is in fact a tailwind, and when combined with exposure to the still robust US consumer, makes the market appear attractive when compared with European high yield, where higher exposure to banks and a lack of illiquidity premium on small-scale corporates leave us cautious at current valuations.
Jeremy Lang, manager of the Ardevora Global Equity Fund
Our investment process is grounded in cognitive psychology and aims to exploit biases inherent in the three participants in equity markets: company management, analysts and investors.
Our framework pushes us to ponder the following question. Where is management behaviour appropriate for the conditions they face? Circumstances look like they are shifting and getting more difficult. This can be dangerous, since management behaviour is both habit-forming and biased to optimism. If managers have become used to finding growth easy, they can be biased in the way they view a slowdown. Oil is a good example of this.
The key debate for the outlook for oil is ‘what is normal’? We think capital intensive Chinese growth and OPEC are not normal conditions in the long term history of oil. Using the last 20, or even 50 years, as a basis to make predictions about the oil price looks to us to be especially error prone. Hence, businesses which have looked good over the last 10 years may have been relying on conditions unlikely to be repeated.
Greg Bennett, co-manager of the Argonaut Absolute Return Fund
At the start of 2015, the median oil price being used by analysts was $80 and $85 for 2015 and 2016. Currently it is $55 and $58 – a 30% cut in the most important modelling assumption – unsurprisingly resulting in negative earnings revisions. Notwithstanding these earnings revisions, many oil stocks remain resilient. This is because most analysts and investors believe oil will be materially higher in the near future and are looking through current weak earnings.
However, the world has been over-producing oil every quarter from the start of 2014. Since oil was last over $100, global production is up 3.6m bbl/day. The largest contributors to supply growth has been Iraq and Saudi Arabia, Russia, the Gulf of Mexico and Asia. Even if, as the IEA expects, US shale production falls by 600k bbl/day next year, the world currently over-produces oil by 1.6m bbl/day. Also, global inventories are at levels not seen for more than two decades. The clear risk is oil continues to stay at current levels, or lower, over the near term. Producers will not cut due to economics, while Saudi Arabia is unlikely to cut until it achieves its aims. This would mean significant downward revisions to earnings expectations and valuations for the sector. Equally, it will mean recent M&A and debt issuance, based on budgeted higher oil assumptions, may not be as economical as first thought. A veritable house of cards.