“Every now and then when your life gets complicated and the weasels start closing in, the only cure is to load up on heinous chemicals and then drive like a bastard from Hollywood to Las Vegas.”
-Hunter S. Thompson
There is a third factor underpinning the state of the world today apart from the COVID-19 virus and concurrent economic recession: oil. On average, about 60% of the world’s oil goes towards making transportation fuels, whose demand collapsed as the result of global governments urging citizens to stay home. This unprecedented demand-destruction occurred against the backdrop of a critically ill-timed price war between Saudi Arabia and Russia. The result? The price of WTI oil fell precipitously from $61 per barrel at the end of 2019 to $21 today.1
Most recently, on April 12th, 23 countries agreed to collectively withhold 9.7mn barrels of oil a day (~10% of supply) from global markets representing the biggest production cut deal in history.2 The effect on oil prices was limited, however, as the demand picture remains uncertain and storage capacity is still projected to become overwhelmed in the coming weeks.
Simply put, oil is the cheapest it has been in almost 20 years and is at levels that are unprofitable for even the lowest cost producers.
S&P 500 Energy stocks are down 46% YTD while crude is down 67%. It’s true, many consumers and businesses benefit from lower oil prices. However, this rout spells trouble for oil-producing countries, like the US, whose oil and gas industry accounts for ~5% of jobs.3 Further, as the Energy sector’s capital investment decreases, storage capacity disappears and production is cut, the knock-on effects can then be felt across the global economy.
With significant leverage and a steep 2021/22 maturity wall (see Exhibit 2 above), the US Energy industry, and, particularly, the US shale oil drillers are facing an existential threat at current oil prices. Of course, the higher-rated and publicly traded companies are better positioned to survive given their ability to raise capital on less punitive terms. That said, no oil producer will escape unscathed by this crisis.
In the High Yield market, we have seen a dramatic increase in High Yield Energy spreads and yields. Option-adjusted spreads on the Bloomberg-Barclays US High Yield Energy Index jumped from 612bp in January to a peak of 2310bp on March 20th, receding thereafter to 1500bp on April 14th – still distressed levels. Even after the recent rebound, the spread widening lead to total return losses of 28% for HY Energy investors year-to-date.
We could not have predicted this situation, nor can we say with certainty whether current levels are appropriate. However, our H-Factor focused approach significantly outperformed the market during this volatile period. Here, we will look into what lead to that substantial outperformance.
We believe that human biases cause market participants to interpret vague and ambiguous information in a systemically incorrect way. The H-Factor risk we identify and measure increases with the risk that companies will fail to meet current market expectations. By avoiding companies with the highest H-Factor scores, we construct a portfolio of bonds issued by companies least affected by this type of risk. We believe this results in outperformance versus the benchmark in most market conditions.
This underweight is the result of two factors that drive our security selection process: the H-Factor score and the focus on public companies with meaningful market capitalizations. At the beginning of the year, Energy had the second highest (worst) H-Factor score in the index. The score had spiked in the second half of 2019, signaling caution, having closely tracked the index for nearly two years prior to that. As a result, our index that began the year with 12% exposure to Energy ended it at under 5%.
Further, our investible universe consists of public companies and, at times like these, the superior transparency and better access to capital that they commonly enjoy becomes a meaningful differentiator.
In essence, exogenous shocks like the ongoing meltdown in the Energy sector are impossible to predict, but prudent high yield bond investors can position themselves to outperform through many different market conditions by focusing on companies least likely to fail. With the H-Factor methodology, we believe we can identify names that have the highest risk of missing expectations and actively avoid their securities. Successful bond investing is predominantly about avoiding losers and we believe that our actuarial, rules-based approach lends itself well to fulfilling that task and generating above market returns.
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1. Bloomberg Data CL1 Commodity as of 4/14/2020
2. 2020 U.S. Energy & Employment Report as produced by NASEO & EFI
3. OPEC and allies finalize record oil production cut after days of discussion by Pippa Stevens on 4/12/2020
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April 24, 2020