PIMCO has long expected the U.S. energy revolution to play a critical role in increasing U.S. energy independence, lowering global energy prices and stimulating U.S. economic growth. While the magnitude of the recent drop in oil prices came as a surprise to many – and caused dislocations in the global credit markets, particularly in certain energy subsectors – it has also created pockets of value.
With an eye on benefiting from this recent volatility, we are leveraging our rigorous global investment process, which combines detailed bottom-up analysis with our top-down macroeconomic views. To that end, we have been highly proactive in managing our energy exposure, favoring subsectors and companies with strong asset quality, high barriers to entry, solid production profiles and strong balance sheets and liquidity profiles.
Lower for longer
Both the precipitous fall of Brent crude oil – from $115 per barrel in June 2014 to below $50 per barrel by mid-January 2015 – and OPEC’s concurrent decision not to cut production were widely unexpected by market participants. However, the secular supply and demand dynamics that have pushed energy prices lower have long been on our radar. During our most recent Cyclical Forum, we reaffirmed our belief that the U.S. is in the midst of a supply-driven energy revolution, and it is unlikely that oil will return to the triple-digit price range over the cyclical (six- to 12-month) horizon.
The primary driver of declining oil prices is the U.S.-led upside surprise in global energy production. U.S. crude output recently topped 9 million barrels per day (b/d), according to monthly Energy Information Administration (EIA) data, up from an average of 5.6 million b/d in 2011. Natural gas production is also surging and U.S. production in natural gas liquids (NGLs) recently surpassed 3.1 million b/d, up from 2.2 million b/d in 2011. This surge in production can be attributed to increased drilling, as well as improved productivity from drilling techniques including hydraulic fracturing. While we anticipate near-term U.S. production growth will decelerate, it will still grow even if oil remains below $60 per barrel due to the lag in time it takes to adjust capital spending plans and projects already underway.
While oil prices had already weakened ahead of OPEC’s 27 November meeting, Brent crude fell even further when OPEC opted to not cut its production quota below 30 million b/d in order to support oil prices, an apparent change from previous behavior. As PIMCO portfolio manager Greg Sharenow discussed in his December 2014 Viewpoint, years of diverging economic fortunes and growing political differences have led to increasing divergence within OPEC. Its leader, Saudi Arabia, further demonstrated that it was unwilling to act unilaterally to support oil prices, having tried and failed from 1981 to 1985. Ultimately, the cartel chose to allow prices to fall further, leaving high-cost shale producers in the U.S. to shoulder some of the supply adjustment. By OPEC’s logic, lower oil prices may slow investment in alternative supplies, meaning a near-term price decline may open the door for longer-term price stability and maintenance of OPEC’s oil market share.
Finally, slowing energy demand growth is also contributing to falling oil prices. In the U.S., improved energy efficiency and stricter Corporate Average Fuel Economy (CAFE) standards have led to lower oil consumption, which is now about 9% below its 2005 peak. We anticipate an uptick in energy demand in 2015 on the heels of strong U.S. economic growth; however, efficiency improvements mean the U.S. will need to grow at a faster rate than it has in the past in order for economic growth to translate into higher energy demand. In an attempt to moderate demand growth owing to lower energy prices, other countries have also taken the opportunity to reduce subsidies and even increase prices elsewhere. Combine this trend with modest European 2015 GDP growth (around 0.75% to 1.25%), and decelerating Chinese 2015 GDP growth (around 6.0% to 7.0% from an average of 9.9% from 2004 to 2013), and demand growth will likely remain muted.
Winners and losers
The precipitous decline in oil prices has generated a windfall for some and a burden for others. Some sectors have rapidly repriced and experienced the brunt of the damage, while others have not yet priced the more lingering impact of low energy prices. This means the time is ripe for investors to differentiate between the winners and the losers across countries, sectors and individual companies.
U.S. consumers are the primary beneficiaries of lower crude and gasoline prices. In 2013, they spent about $330 billion on gasoline and motor oil, according to the Bureau of Labor Statistics. Today’s national average gasoline prices are about 39% lower than in 2013. If they remain stable, this translates into an additional $129 billion (0.7% of GDP) of spending power. Airlines in particular will ride the tailwind from cheaper oil and rising spending, as will lodging, gaming and other consumer discretionary sectors. Manufacturers will benefit from lower input costs, which, when combined with lower energy imports (and growing U.S. natural gas and NGL exports), will help the U.S. trade balance. These trends and others, including low interest rates and an improving labor market, should further support U.S. economic growth. To be fair, lower energy-related U.S. capital expenditures (capex), which were around 1.2% of GDP in 2014 (source: U.S. Bureau of Economic Analysis), would be a drag to U.S. GDP in 2015. However, they will likely be offset by an increase in spending by consumers, given their lower energy bills.
Other beneficiaries of lower energy prices are developed countries/regions and oil importers including Japan, Europe, India and South Korea. In particular, China, the second-largest energy consumer and the largest oil importer, will likely experience improving terms of trade.
While many global central banks are concerned about disinflation, the decline in input costs would be the “good” kind of deflation for consumers, since it will act as an economic tailwind, and lower inflation will better allow central banks to continue to keep interest rates accommodative. Financial assets in these countries could continue to perform well given this backdrop, particularly in regions of the world where private sector fundamentals are improving. A technical risk to this outlook is if oil exporters and their sovereign wealth funds raise dollars by selling the financial assets they have been acquiring over the past several years.
Who are the losers? Energy exporters will feel the pinch of lower oil prices as trade balances deteriorate and fiscal conditions worsen. Venezuela, which relies on oil exports to generate dollars and purchase basic goods for its populace, faces a challenging macroeconomic adjustment amid declining reserves that stretch its capacity to continue servicing its debt. Russia is also feeling the dual shock of corporate-sector sanctions and declining export revenues, which have contributed to a weakening ruble and slowing economy. However, while both countries are vulnerable to oil price declines, Russia’s $389 billion in international reserves offers substantial cushion to absorb these shocks, while Venezuela may exhaust its reserves in the next year or two if it is shut out of the capital markets. The vulnerability of other oil-exporting countries varies depending on fiscal breakevens and foreign exchange asset positions. For example, Saudi Arabia has a fiscal breakeven in the mid-$70s per barrel but, with $744 billion in international reserves, it can sustain lower oil prices for an extended period of time.
Some oil field servicers – and drillers in particular – may face financial distress from lower oil prices. Companies with low asset quality, high leverage and weak balance sheets are highly vulnerable to long periods of low oil prices. Drillers have already experienced significant underperformance in 2014, and their spreads may widen even further. However, while a select group of these companies may become insolvent in the future, the U.S. energy industry’s debt maturity profile is favorable. In 2015, high-grade energy debt maturities total $22.4 billion, or 5.1% of all U.S. high-grade energy debt and 0.4% of all U.S. high-grade corporate bonds (sources: Wells Fargo Securities, Barclays and J.P. Morgan). Even less U.S. high yield energy debt is maturing: In 2015, maturities total $450 million, or 0.3% of all U.S. high yield energy debt and 0.03% of all U.S. high yield corporate bonds (sources: Wells Fargo Securities, Bank of America Merrill Lynch and J.P. Morgan). This maturity profile suggests that even if high-cost energy producers and drillers with weak balance sheets are a casualty of lower energy prices, the impact of their eventual insolvency has minimal contagion risk until 2016 or later.
PIMCO continues to leverage our top-down macroeconomic framework, which guides our cyclical and secular views, with a bottom-up process that informs our sector and issuer selection. We believe we can generate alpha in the global credit markets by actively managing our energy exposure and tailoring exposures within the sector. Over the past decade, we have spent considerable time and dedicated numerous resources on the ground, meeting executives, inspecting operations, evaluating various energy basins, analyzing logistics and cost structures, and examining financial statements. In general, we favor companies with high barriers to entry and high quality assets that allow production at a low marginal cost, and that have strong liquidity and balance sheets.
For over a year, PIMCO has been shedding exposure to oilfield service companies – companies that contract with the energy exploration and production (E&P) industry but usually do not sell oil or natural gas on the market. We continue to believe this sector is especially vulnerable to an oil price shock; as oil prices decline, E&P companies delay capex, and some projects may get shelved indefinitely, leaving oilfield service companies without work. We have witnessed this phenomenon already with offshore drillers, as day rates (or the rate at which offshore drillers charge other companies) have fallen this year. If day rates remain depressed, leverage quickly rises and the ability to service debt may become impaired. For this reason, we maintain a cautious approach to this sector.
We have maintained a selective approach to E&P; however, we have been focusing on issuers that have strong balance sheets with low leverage. Among E&P companies, our largest underweight has been in higher-risk producers with high production costs, large upcoming nondeferrable project-related capex payments and/or high ongoing funding needs. We remain favorable on select pipelines given their long-term contracts and lower sensitivity to commodity prices. Finally, we remain cautious on integrated oil companies; while their balance sheets are generally stronger, their tight spreads limit their attractiveness.
Default risk in the energy sector is largely concentrated within the high yield universe. Of these high yield energy sector bonds, 20.3% trade at distressed valuations (defined as an option-adjusted spread greater than 1,000 basis points), representing 2.7% of the overall U.S. high yield bond market (source: PIMCO). During 2014, we maintained a cautious stance toward the riskiest names in energy exploration and oilfield services. However, distress in the high yield energy sector also provides an opportunity for 2015. We believe we can find diamonds in the rough by identifying securities that are trading at distressed valuations but are sufficiently senior in the capital structure or have bondholder-friendly covenants. Additionally, PIMCO’s broad platform, expertise and relationships with management help us to invest in companies through reverse inquiry. Taken together, these approaches should help us pick winners and avoid losers, targeting strong relative performance.
More broadly, following the rapid decline in oil prices and underperformance of U.S. Treasury Inflation-Protected Securities (TIPS), we believe these securities are now attractive. We also favor the dollar against other currencies owing to accelerating U.S. growth, lower U.S. trade and fiscal deficits, and a less accommodative Federal Reserve. Finally, non-U.S. production companies that generate dollar revenue but incur costs in their domestic currency should benefit in a strong dollar environment relative to their U.S. peers.
Opportunities in energy
While the magnitude of the decline in oil prices may have come as a shock to many investors, it has generated significant opportunities moving forward. We believe our longer-term investment horizon, understanding of global macro factors and focus on fundamental analysis will prove to be differentiating factors that will allow us to find total return opportunities in companies that we believe have sufficient liquidity to withstand the current commodity price downturn. We believe we are moving into an extended period of lower oil prices, and we are actively managing our clients’ energy exposure with an eye toward benefiting from recent events.