Déjà vu?

November 15, 2018

Source: Bloomberg Source: Bloomberg

In early October 2018, the price of oil (as measured by West Texas Intermediate – WTI) hit highs not seen since late 2014. As the month moved on, however, the price of oil corrected by almost 25% from a peak of over $76 to current prices below $57. When a commodity price corrects by that magnitude in such a short period of time, it’s worth taking a closer look. Moreover, the energy sector accounts for almost 16% of the J.P. Morgan U.S. High Yield Index (USHY), so there is plenty of corporate debt we can examine for potential investment opportunities. 

The energy sector is one of the largest sectors in USHY and has been a key driver of returns for the asset class. Throughout October, most risk markets suffered from price corrections. Emerging market equities, for example, were down over 8.5%, while the S&P 500 Index was down over 7%, USHY down almost 1.8% and investment-grade down nearly 0.7%. Even leveraged loans and an investment in the 10-year U.S. Treasury bond were both slightly negative over the period. Returns for the USHY Energy Index were down almost 2.7%, underperforming the broader USHY Index. Additionally, the S&P 500 Energy Index was down 12.5%, also materially underperforming the broader S&P 500 market. 

Given the risk sell-off overall and the larger price correction for oil, I think high yield (HY) energy has held up relatively well. Looking at HY energy specifically, these companies are much better prepared this time around (compared to late 2014). Many have reduced total debt and leverage, decreased fixed costs such as interest expense and maintenance capital expenditures, lowered costs to run their businesses, as well as hedged future cash flows. As a result, many of the HY energy companies that we research are positioned to survive in an environment when oil is $50 and lower. This seems to be demonstrated by the relatively muted correction in HY energy prices compared to the end of 2014. At that time, when oil prices declined about 20% from $76 to $61, HY energy bonds declined over 8.5%, which was much larger than the -2.5% return for USHY over the same 20-day time period. Overall, the moves in energy bonds in October 2018 seem to support the market’s view of better underlying fundamentals this time around.


Key Takeaway

Today, USHY Energy companies have stronger credit fundamentals, lower fixed costs and are better positioned to weather lower oil prices. With that said, if oil prices continue to move lower, I would continue to expect HY energy credit spreads to underperform, albeit not to the same degree as when oil prices went below $60 for the first time. It is too difficult to predict where oil prices will go next. The key is to do the research and discover the companies that should be able to survive throughout the full cycle, and make sure the spread compensates you for that level of risk.  

Tags: oil prices | USHY Energy Index | Commodities

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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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