Matthew Waterman, Investment Writer, New Age Alpha Apr 24, 2020 7:22:00 AM 8 min read Stock Insights

High Yield Energy Sector Meltdown: Fear and Loathing in Oil and Gas

“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.

NAA_Fear and Loathing_1-01S&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.

 

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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.

 

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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.

 

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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.

 

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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%.

 

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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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Footnotes:

1. Bloomberg Data CL1 Commodity as of 4/14/2020
2. 2020 U.S. Energy & Employment Report as produced by NASEO & EFI
https://static1.squarespace.com/static/5a98cf80ec4eb7c5cd928c61/t/5e78b363087a892473ac6cdf/1584968554743/2020+USEER+EXEC+0323.pdf
3. OPEC and allies finalize record oil production cut after days of discussion by Pippa Stevens on 4/12/2020
https://www.cnbc.com/2020/04/12/opec-and-allies-finalize-record-oil-production-cut-after-days-of-discussion.html

Disclosures:

The above statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. It is not possible to invest in an index. An investor utilizing the index may experience a loss. No client or prospective client should assume that any information presented in this report serves as the receipt of, or a substitute for, personalized individual advice from New Age Alpha or any other investment professional. Any charts, graphs or tables used in this report are for illustrative purposes only and should not be construed as providing investment advice and should not be construed by a client or a prospective client as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice. All research and data are simulated and should not be considered indicative of the skill of New Age Alpha. The research data presented for the index has been calculated backwards in time and is not a contemporaneous record of actual assets managed by New Age Alpha. The performance results are gross of fees and expenses and reflect the reinvestment of coupon payments. Given the limited history of the index, the information presented above does not reflect the effective applicable fees and the performance has not been adjusted to give effect to such fees in any product using this index. Data for the 1 Year, 3 Years, and 5 Years and since First Value Date periods is hypothetical and back-tested. Unless otherwise noted, data for the Calendar Year Return period is hypothetical, not annualized and back-tested. Back-tested performance is provided for informational purposes only. New Age Alpha’s back-tested results do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of the investment strategy that was designed with the benefit of hindsight. Thus, the simulated performance results noted herein should not be considered indicative of the skill of New Age Alpha and are not representative of the actual performance results that are or could be attained by clients of New Age Alpha. The results do not necessarily reflect the impact that any material market or economic factors may have had as the result of following this investment strategy. Returns less than a year are not annualized. COVID-19 This report includes forward-looking statements. These statements are not historical facts, but instead represent only our presenting beliefs regarding future events, many of which, by their nature, are inherently uncertain and outside of our control. Forward-looking statements include statements about the potential efficacy of diagnostic and treatment efforts and their potential impact on the global outbreak of a novel strain of coronavirus (COVID-19). Any impact of these measures on the results of the companies presenting or on financial markets or national economies more broadly is uncertain. As at the time of this report, the COVID-19 outbreak is resulting in widespread disruption to financial markets and normal patterns of business activity across the world and has led to significant market volatility and accommodative monetary policies by global central banks and companies around the world activating business continuity planning (BCP) strategies to safeguard the well-being of employees, the continued operation of critical functions and the support of clients and customers. The extent of the impact of these measure on the COVID-19 outbreak and on the companies’ operational and financial performance, and on the markets and national economies more generally, will depend on future developments including the efficacy of these measures and the duration and continued spread of the outbreak. All New Age Alpha trademarks are owned by New Age Alpha LLC. All other company or product names mentioned herein, including Bloomberg L.P. and ICE Data Indices, LLC and its affiliates, (“ICE”) are the property of their respective owners and should not be deemed to be an endorsement of any New Age Alpha product or fund. As used in this document, First Value Date means the first date New Age Alpha used to calculate its back-tested data for its hypothetical performance analysis. It should not be interpreted to mean the inception date of any such fund or strategy.

April 24, 2020

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