The dramatic decline in oil prices over the past six months is unlikely to reverse itself for the foreseeable future, and indicates that OPEC has lost control of the market, according to a panel of experts at a recent Legg Mason-sponsored event in the US.
In a lively discussion entitled “Ripple or Tsunami? Assessing Oil’s Future Impact on the Markets” moderated by Consuelo Mack, executive producer and managing editor of Consuelo Mack WealthTrack, respected analysts from Western Asset offered their perspectives on structural changes to the energy market. The consensus: the decline in oil prices represents a “tsunami”—a long-term shift that could hold per-barrel prices in the $50-$60 range for the next several years.
“Last October, with US oil production surging, the Saudis and other countries such as Oman, Kuwait and the United Arab Emirates started discounting the price of oil to Asia in an effort to keep share. At the OPEC meeting a month later, there was an expectation that the cartel would use its natural control of the market to adjust the perceived supply-demand imbalance, but nothing was done—a signal that OPEC had lost control and that the cartel effect was over,” said Western Asset Research Analyst J. Gibson Cooper. This created a dramatically altered landscape that has forced financial advisors to rethink fundamental investment strategies.
The good news, said Ryan Brist, head of US investment at Western Asset, is that, from a portfolio perspective, “you’ve got a lot of time here”—a sentiment echoed by Cooper. “Our expectation is you will see defaults rise moderately in the energy sector,” he said. “We don’t think 2015 is a year of massive pain for high-yield energy credits generally.
Given our view that oil will probably stay around this price for a couple of years, 2016 is a bigger question.”
For now, Cooper continued, the energy market remains appealing. “Yes, defaults will rise, but we think current spread levels and prices overcompensate for default risk,” he said.
Brist indicated there may be downside risk in the high-grade marketplace, but that other opportunities abound.
“There’s a great dispersion in energy and, especially in emerging markets like Russia and Brazil, where we’re talking about fraud and government intervention, I’d be cautious. But high yield looks pretty interesting; from a portfolio perspective, that would be my focus.”
Cooper drilled down even further within high yield, which, he pointed out, is an extremely large market. “Broadly speaking, it’s three major sectors: exploration and production, oil service companies and then the midstream sector. That midstream space is still a large part of our strategy. Nearly all of those are structured as master limited partnerships (MLPs), and we think that subset of energy will do just fine under any commodity environment.”
Right now, the analysts affirmed, the name of the game is liquidity. “The question,” said Cooper, “is whether you can build levers or bridges in your business to withstand a low commodity environment. Our assumption is that not everything works at $50-$60 in the US, or even globally.”
Additionally, upside risks always exist, particularly, said Cooper, with a cartel that controls 30 million barrels per day of production. “We’ve seen issues in Iraq, Libya has been a concern and there’s a big election in Nigeria that keeps getting postponed, it’s very violent and we’ve seen production in fits and starts there.” But this past quarter, he noted, everything has gone right for production: The US has been doing well, OPEC production has been strong and volatility has stayed low.
All of this, as Brist sees it, reduces the chances of a dramatic surprise in oil prices. “Analysts are very good at counting barrels on the supply side, but demand is a hard thing to gauge,” he said. Yet, based on current conditions, he continued, “I think the base case—that $50-$60 per barrel price—is our highest probability.”
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