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J. GIBSON COOPER
Research Analyst
RENÉ LEDIS
Research Analyst
Oil Market Volatility Provides an Opportunity for Value Investors
Executive Summary
ƒƒ Crude oil markets have experienced unprecedented volatility.
ƒƒ The capital market’s response
has been swift and severe.
ƒƒ A broad contraction of global
energy activity is expected.
ƒƒ Short-term oil price volatility
should give way to longer term
stability at higher price levels.
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.
Exhibit 1
Oil Prices and Futures
ƒƒ Patient, longer term investors
will likely be rewarded.
160
140
Oil Price Curve (USD)
120
100
80
60
40
4/30/2007
11/29/2013
20
0
2006
2007
2008
2009
Futures Curves at Various Points in Time
6/30/2008
9/30/2008
6/30/2014
9/30/2014
2010
2011
2012
2013
12/31/2008
11/28/2014
2014
2015
2016
Source: Bloomberg. As of 19 Dec 2014
Source:
Bloomberg.isAsaofhighly
19 Dec 2014
The energy
industry
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.
© Western Asset Management Company Ltd 2014. This publication is the property of Western Asset Management Company Limited and is intended for the sole use of its clients, consultants, and
other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or
used in any form or medium without express written permission.
Oil Market Volatility Provides an Opportunity for Value Investors
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.
Exhibit 2
World Oil Supply and Demand
Supply Balance vs. Oil Price
120
Brent Oil Price (average) (left scale)
2.5
Supply Balance (right scale)
2.0
1.5
80
1.0
0.5
60
0
40
-0.5
20
Supply Balance (MMb/d)
Brent Oil Price ($ per barrel)
100
-1.0
-1.5
0
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012 2014E
Source: International Energy Agency (IEA), Bloomberg, Western Asset Management
Source: International Energy Agency (IEA), Bloomberg, Western Asset Management
Western Asset
2
December 2014
Oil Market Volatility Provides an Opportunity for Value Investors
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.
Historical Energy Spread vs. Market
Exhibit 3
Historical Energy Spread vs. Market
Spread Difference (basis points)
400
200
Investment-Grade Energy Minus Investment-Grade Index
0
-200
-400
-600
Jan
05
High-Yield Energy Minus High-Yield Index
Jul
05
Jan
06
Jul Jan
06 07
Jul Jan
07 08
Jul Jan
08 09
Jul Jan
09 10
Jul Jan
10 11
Jul Jan
11 12
Jul Jan
12 13
Jul Jan
13 14
Jul
14
Source: Barclays Live. As of 17 Dec 14
Source: Barclays Live. As of 17 Dec 2014
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.
Western Asset
3
December 2014
Oil Market Volatility Provides an Opportunity for Value Investors
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.
Western Asset
4
December 2014
Oil Market Volatility Provides an Opportunity for Value Investors
Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained
herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject
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Western Asset
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December 2014
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