High Yield Energy: Paths of Valuation and Correlated Effects
An observer may rightly state the bull case for oil and related investment thesis is not one of prescience but only precarious sentiment. True a simple wager on the directional valuation of commodity pricing may set the course, perhaps even amplified by modest use of leverage. In the Energy sector, valuating macroeconomic drivers consistent with the permutations of effects on corporate performance is measurable in degree though often variable in the most desired performance metric—timing.
Attempting to forecast the performance of Energy-Oil & Gas securities exemplify this modeling challenge, demonstrated over the past year by absolute total return volatility ranged between 60 and 100% across zero. Developing a portfolio strategy to exploit market dislocations is advanced by assessing relative value opportunities across capital structures, equating performance characteristics among corporations by designated asset class benchmarks and along sector/subsector proxies.
To begin note High Yield debt represents 50% of Energy sector bond issues outstanding, an indication of its industrial nature and risk intensity. Decomposition of High Yield Energy based on BofA Merrill Lynch High Yield Master Index (II) protocol reveals four classifications within the Industry/Subindustry structure: Exploration & Production, Oil Field Equipment & Services, Gas Distribution and Oil Refining & Marketing. Matched initially with equity-based proxy benchmark Energy Select Sector SPDR Fund (XLE) then deconstructed, subsector composites SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and Market Vectors Oil Services ETF (OIH) are assigned to corresponding BofAMLHYMIii subindustries and a tandem comparative array is complete.
This methodology enables pairing of option-adjusted High Yield bond spread inversions with equity-based period price changes, important to establish relativity and illustrate the risk/return characteristics of aggregated capital structures within segments of the two most economically sensitive Energy subsectors (Exploration & Production and Oil Field Services). Graphically, combined intervals delineate paths of valuation for 2015 YTD in both segments:
Here the appearance of convergent concurrent parallel trends among the four asset class and subsector proxies reveals an industry group absent a sustained revenue driver (oil prices), wherein representative Exploration & Production and Oil Field Services company balance sheets lack significant incremental marginal free cash flow to transit from the top of the capital structure after maintenance (bank loans, bonds) to the bottom (equity). The traditional transfer of wealth from bondholders to shareholders does not occur to the detriment of one another. Liquidity analysis further demonstrates the adverse effects of industry supply-side economics on marginal free cash flow as peak-to-trough interest coverage for High Yield Energy falls dramatically, from 4.7x to 0.7x (source: Guggenheim Partners). In sum, deteriorating financial metrics pare conventional debt versus equity distinctions.
Examining High Yield within the context of associated, tradable equity-based asset classes provides useful parameters of decision making as forward looking equity proxies anticipate near-term cash flow needs and projected levels. In lieu of proprietary sources, publicly traded ETFs (a combination of iShares, SPDRs, Market Vectors and ProShares) are provided in the table below as benchmark comparables. Niche-focused equity standards (Russell 1000/2000, IWB/IWM) and a matrix of Large-Cap Value/Growth (JKF/JKE), Mid-Cap Value/Growth (JKI/JKH) and Small-Cap Value/Growth (JKL/JKK) asset class proxies are considered with Energy sector benchmark (XLE), determined Exploration & Production/Oil Field Services/Unconventional subsector composites (XOP/OIH/FRAK) and West Texas Intermediate crude pricing (USO):
Correlations on a trailing 12-month basis (103115) demonstrate consistently strong relationships between High Yield (HYG) and Mid-Cap Value (JKI), the Energy sector as a whole (XLE) and its composites (XOP/OIH/FRAK) to Large-Cap Value (JKF) and Mid-Cap Value (JKI) plus the explicit effects of oil prices (USO) on successive subsectors of graduated higher risk profiles (XOP/OIH/FRAK).
In establishing an investment narrative, outlining first and second order effects of commodity pricing on corporate performance is necessary to capture changes in near-term subcycles within greater sector cyclicalities. First by designating a financial marker, in our case incremental marginal free cash flow, then by projecting its ability to recapitalize the balance sheet over time. Monitoring divergent or confluent movements of aggregated corporate performance through capital market price action (theoretically the present value of all known or anticipated corporate actions, company catalysts and externalities) lends perspective while the characterization of established relationships among asset classes adds dimension. Interpreting industry dynamics by expected changes in the slope of supply/demand curves and interpolating effects of commodity strip pricing on security valuation are endeavors embedded within modeled sensitivity/scenario analyses.
The current operational emphasis in Energy-Oil & Gas on short-cycle projects, joint ventures, capital divestment and noncore asset monetizations are clear signs of stress. However, on a macro and secular level known today are: 1) inherent in the Fed’s outlook on inflation is a normalization of oil prices, 2) OPEC’s five-year forecast is in contango and 3) the world population growth rate (1.1%) is approximately equal to that of hydrocarbons. Looking forward, independent research suggests investors may be well-served by being long oil over a 12-15 month time horizon via the accumulation of Mid-Cap Exploration & Production and Oil Field Services companies at points of inflection with exposure to select basins and potential for turnaround—an opportunity to grow Value.