Volatility and uncertainty in the energy market

Below is what Kathleen Gaffney form Eaton Vance Corp., has said about volatility and uncertainty in the energy market.

“We believe the current price of oil 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 suing the current sell off in markets to selectively add risk.”

Causes of the oil price decline

“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 to share the burden of adjustment. On the demand side, lower expectations are likely being driven by economic weakness in China, Japan and the EU, as well as developments in Russia.”

Stopping the decline

“It is truly impossible to say for certain where the bottom will be. High quality US producers maintain full cycle costs at or near current crude prices. And importantly, given decline rates in US shale production, we thin 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 US$40 /bbl during the financial crisis in 2008 serve as a guidepost. However, unlink the credit crisis, 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 US, 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.”

Impacts of the price decline

“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 companies have the liquidity, hedge book and ability to focus on low cost plays to weather this storm. We recognise defaults in the energy sector may pick up, and mergers and acquisitions opportunities will no doubt be presented. It is our focus to seek the companies with the strongest outlook in this challenging environment."

Personal reaction to the oil price decline

“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 US onshore, we have focused on top tier oil and gas names in lower costs basins. For offshore, we have focused on well contracted drillers with low leverage per rig and high day rates. Outside the US, 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 basked 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 many 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, capitalising on markets as they punishingly price in uncertainty. We firmly believe this is the best way to create long term value.”

Edited from press release by Claira Lloyd

Published on 14/01/2015

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