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October 22, 2015 - One area seeing a sell-off today (10/21/2015) is worth commenting (and I'm not talking about this one). Generic crude oil has dropped to $45 following the latest Department of Energy report showing an 8.028-million-barrel inventory build in crude stocks, the largest inventory build over the last 6 months. It looked like energy was on the mend following the steep 3Q sell-off which saw prices drop from $55-60 to $38-40 and then recovering to the high $40s (Exhibit 1). Over the past year when OPEC first announced it was going to target market share at its Fall 2014 meeting, oil has dropped 46% from year-ago levels. During the 2nd quarter, oil recovered to $55-60 before dropping again over global supply concerns exasperated by slowing global industrial activity, notably in China.

Exhibit 1: Generic Oil 1 Month Contract (1-Year Ending 10/19/2015)

Oil Chart 1.png

Supply continues to remain an overhang as OPEC and U.S. energy producers fight to see who can hold out the longest. Many of the U.S. producers are highly leveraged and are facing an October redetermination by their creditors where lower oil prices could trigger a massive withdrawal of debt financing. However, it appears many of these companies have gotten a reprieve until next spring as their bankers have decided to roll over their credit lines until the next review. The volatile price swings and blow-out in U.S. credit spreads suggested that the Saudis would prevail as we approached the October calendar, but the IMF released a report suggesting that the Saudis may be closer to the cliff despite being the world's lowest cost producer. OPEC nations hoped they could squeeze the higher marginal cost producers out of their needed financing, but the race to the bottom will have to continue until bank financing or OPEC public financing dries up.

The Great Shale-Space Coaster

For tactical, sector-rotation investors, the roller coaster ride has been anything but great. Consider the daily gyrations of the S&P energy sector's return ranking (out of 10 sectors) since the start of the third quarter (Exhibit 2):

Exhibit 2: S&P Energy Daily Return Rank vs the Other Nine Sectors (7/1/2015-10/20/2015)

Energy Sector Chart 1.png

To put this in additional perspective, the median daily rank change for the energy sector was '4' compared to an average '2.3' median rank change for the other nine sectors. Energy was either the best or worst performing sector 48% of the time versus an average 17%for the other nine sectors. Utilities had a higher percentage (49%) but utilities were the top performer 31% of the time over this period. 

The ride hasn't been any easier for credit investors where energy comprises ~12-13% of both the Merrill Lynch High Yield (Bloomberg H0A0) and Corporate Master (Bloomberg C0A0) indices. Exhibits 3 and 4 show the credit spreads of the energy sectors versus the broader indices. With spreads blowing out resulting in significant capital losses, investors striving for yield have been gifted with a dose of equity beta; this is a reminder that high yield is an asset class to rent not own (more on that in another piece).

Exhibit 3: Investment Grade Corporate Option-Adjusted Spreads Comparing the Energy Sector Versus All Sectors (Source: Bloomberg FICM)

Option Adjusted Spread Chart.pngData through 9/30/2015

Exhibit 4: Investment Grade Corporate Option-Adjusted Spreads Comparing the Energy Sector Versus All Sectors (Source: Bloomberg FICM)

Option Adjustment Spread.png

Data through 9/30/2015

Finally, MLP investors have been hurt to the tune of -25.94% loss YTD through 10/20/2015 (S&P MLP Index). Overall, it has been a difficult quarter and year for energy investors across the capital spectrum. 

The World is Awash in Oil

Weighing on energy sentiment is the state of the global oil market where global supply/demand remains out of balance as producers rush supply into a slowing market (Exhibit 5). As can be seen from the exhibit, the global supply/demand imbalance is at historically wide levels. Either producers have to cut back (whether by voluntary choice or forced to do so by their creditors) or global demand needs to meaningfully pick up. With signs of global growth slowdown, notably out of China, global demand is not likely to accelerate from current levels.

Exhibit 5: Global Supply vs Demand and the 12-Month NYMEX Oil Strip

Global Supply Demand Chart.pngSource: Energy Intelligence Group and Bloomberg; data through 9/30/2015

Furthermore, the world remains awash in oil despite signs of production slowdown in the U.S. as evidence by a drop in U.S. rig counts and nonfarm oil/gas employee payrolls (Exhibit 6).

Exhibit 6: Baker Hughes US Rig Count vs Nonfarm Oil/Gas Payrolls

Baker Hughes Rig Count Chart.png

Source: Baker Hughes and Bloomberg; data through 9/30/2015

All this is not lost on the investment community as speculators hold a record net short position in futures contracts (Exhibit 7). One could argue that negative sentiment has hit an extreme point, but it, nonetheless, reflects a reasoned observation of the supply/demand imbalance plaguing the energy sector.

Exhibit 7: # of Long and Short Crude Light Sweet Oil Futures Contracts: Non-Commercial

Contracts Long Short Chart.png

Source: CFTC and NYMEX; data through 9/30/2015

How energy performs will also determine how 'value' performs. Oil & Gas comprise ~10% of the CRSP US Large Value Index and ~20% for factor-weighted value indices such as the S&P Pure Value Index. YTD through 10/20/2015, the S&P Energy sector and S&P Pure Value are down 12.6% and 7.2%, respectively, although they had been down 21.3% and 12.9%, respectively, through 9/30/2015.


Riding Out Until the End

Regardless of who runs out of time first (OPEC or US Shale), fossil fuel consumption will not likely change over the near-term and global oil demand will continue to grow, albeit at a slower pace. For those tactical investors that have successfully navigated the energy swings, my hat off to you. As strategic investors, one must adopt a long-term perspective and ride out the short-term fluctuations. The volatility in energy reinforces the importance of long-term investing and diversification as such volatility has a knack for showing up in unexpected places.