Volatility and uncertainty in the energy market
Kathleen Gaffney on the decline in oil prices as an opportunity
Author: Kathleen Gaffney
BOSTON, Jan. 13, 2015 /PRNewswire/ --
SUMMARY
We believe the current price of oil (WTI crude below $55 per barrel as of December 22, 2014) is likely below its longer-term equilibrium level and, as such, we think it represents value for opportunistic investors. Importantly, we do not view the repricing of oil as a catalyst for contagion and are using the current sell-off in markets to selectively add risk.
What's causing the decline in oil prices?
The decline in oil prices over the past several months is the result of both oversupply and weaker demand, with oversupply being the more dominant driver. Technological advancement in shale has led to a significant increase in North American productivity, while OPEC has stated the need for the global industry (not just its members) to share the burden of adjustment. On the demand side, lower expectations are likely being driven by economic weakness in China, Japan and the European Union, as well as developments in Russia.
When will the decline stop?
It is truly impossible to say for certain where the bottom will be. High-quality U.S. producers maintain full-cycle costs at or near current crude prices. And importantly, given decline rates in U.S. shale production, we think it likely takes only a small cutback to capital expenditures and some additional time for production to decline.
Of course, further declines in the price of oil are possible. Oil prices that briefly dipped below $40 per barrel during the financial crisis in 2008 serve as a guidepost. However, unlike the credit crisis (which was demand-driven), we are of the opinion that a supply-driven correction can be more easily balanced with production cutbacks. Additionally, we feel continued above-trend growth in the U.S., increasing needs in emerging markets and the likely stimulus generated by quantitative easing worldwide will fuel demand to a greater degree than what is currently being priced into energy markets.
What is the impact of the decline in oil prices?
The collapse in oil prices has led to a marked increase in capital market volatility, particularly for commodity-related stocks, convertibles and high-yield bonds. And we would not be surprised to see indiscriminate selling pressure in energy company securities continue over the next couple of weeks due to the phenomenon of year-end "window dressing." We feel that many large-cap exploration and production (E&P) companies have the liquidity, hedge book and ability to focus on low-cost plays to weather this storm. We recognize defaults in the energy sector may pick up, and mergers and acquisitions (M&A) opportunities will no doubt be presented. It is our focus to seek the companies with the strongest outlook in this challenging environment.
What's your reaction to the decline in oil prices?
Over the past quarter, we have been selectively adding Eaton Vance Bond Fund's exposure in energy across both the onshore and offshore energy sectors, as well as to select foreign producers. For U.S. onshore, we have focused on top-tier oil and gas names in lower-cost basins. For offshore, we have focused on well-contracted drillers with low leverage per rig and high day rates. Outside the U.S., we have focused on those producers that maintain a significant relationship with, and either implicit or explicit support of, the sovereign.
Early this year we added selectively to offshore drilling. When oil prices began to slide during August and into September, we saw attractive entry points on a couple of new-issue convertibles. We also added international energy companies, particularly in Latin America. As equity weakness increased, we eased into additional exposures in energy-related convertibles. Over the past month, we have been accumulating a basket of large-cap investment-grade domestic oil producers.
Final thoughts
We know riding the downside of the cycle is challenging. However, we seek to embrace this volatility and may continue to see opportunities to spend a portion of the reserves we accumulated earlier in the year to increase the aggregate contribution-to-risk of Eaton Vance Bond Fund, capitalizing on markets as they punishingly price in uncertainty. We firmly believe this is the best way to create long-term value.
About Eaton Vance
Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company's long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today's most discerning investors. For more information, visit eatonvance.com.
About Risk
An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments rated below investment grade (typically referred to as "junk") are generally subject to greater price volatility and illiquidity than higher-rated investments. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant. As interest rates rise, the value of certain income investments is likely to decline. Commercial mortgage-backed securities ("CMBS") are subject to credit, interest rate, prepayment and extension risks. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments. Derivative instruments can be used to take both long and short positions, be highly volatile, result in economic leverage (which can magnify losses), and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk. If a counterparty is unable to honor its commitments, the value of Fund shares may decline and/or the Fund could experience delays in the return of collateral or other assets held by the counterparty. There can be no assurance that the liquidation of collateral securing an investment will satisfy the issuer's obligation in the event of nonpayment or that collateral can be readily liquidated. The ability to realize the benefits of any collateral may be delayed or limited. Fund share values are sensitive to stock market volatility. While certain U.S. government-sponsored agencies may be chartered or sponsored by acts of Congress, their securities are neither issued nor guaranteed by the U.S. Treasury. A nondiversified fund may be subject to greater risk by investing in a smaller number of investments than a diversified fund. No Fund is a complete investment program and you may lose money investing in a Fund. The Fund may engage in other investment practices that may involve additional risks and you should review the Fund prospectus for a complete description.
Past performance is no guarantee of future results.
The views expressed in this Fund Spotlight are those of Kathleen Gaffney and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.
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