Western Asset Management has published a market briefing on global oil and high yield energy, ‘Oil and High Yield Energy Brief’. The company notes that while no significant moves can be forecast, oil prices are unsustainable at current levels, which will likely spur change in the form of pullbacks and consolidations, particularly in the exploration and production (E&P) sector.
"Not much works in E&P domestically or internationally at these prices," wrote the paper's author, Western Asset Research Analyst J. Gibson Cooper. "Despite the tough near term macro backdrop, we continue to believe low crude oil prices will drive the necessary reduction in global industry activity that results in a tighter supply/demand imbalance in the long run, a process we believe will take several years."
"The outer part of the oil futures curve refuses to move beyond the psychologically important US$70/bbl level," said Cooper. "Despite all the noise, the industry is unsustainable at current prices, which means capital will continue to be withdrawn globally until low prices cure low prices."
“The market was exceedingly worried about the US storage situation in the face of continued ramp up in US production and the seasonal trough in refining demand,” Cooper continued. “The storage risk never materialised, and since then, the data points have been generally constructive for tighter future supply/demand (slowing growth in key supply basins, better demand both in the US and throughout the world, high global refining margins and renewed supply disruptions in several countries). Coupled with the sustained lower US rig count and lower expected upstream capital spending globally, the oil futures curve had been gradually moving up on better fundamentals until Greece and China, and its follow on risks grabbed the headlines."
"The threat of an additional 700 000 bpd of oil from Iran, if sanctions related to the country's nuclear ambitions were to lift, seems a manageable near term headwind and there is a fair amount of skepticism that Saudi Arabia can sustain over 11 million bpd over time."
Furthermore, according to the research:
- Renewed macro risks around China, Greece and Iran, and resulting heavy high yield sector outflows over the last two months, have caused energy bond spreads to weaken back to year to date wide spread levels versus the broad high yield index.
- The July 6 futures curve has retreated back toward March lows as the worry has moved from supply to demand.
- For high yield E&Ps, several themes are expected to move to the forefront over the back half of the year: M&A, acquisitions/divestitures and continued liability management. Low commodity prices and declining hedge gains will work to sharpen and shape management teams' decision making processes on corporate survival.
High yield E&P issuers face serious, even existential challenges. "They are hedging to ensure 2016 survival, not to ramp capital expenditures," said Cooper. "Some companies have portions of their inventory continuum that can (using a loose definition) 'make money' but, broadly speaking, the industry is unsustainable at current prices. Capital extraction out of the industry will accelerate quickly in the coming quarters."
Adapted from press release by Rosalie Starling