Tag: episode-1147


May 15, 2015

CONSUELO MACK: This week on WEALTHTRACK, drilling for profits in the energy field. Portfolio managers Gib Cooper of Western Asset Management and Chris Eades of ClearBridge Investments discover opportunities created by falling oil and gas prices next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. One of the biggest stories of last year was the dramatic decline in oil prices and every asset class connected to them. Prices of energy stocks plummeted, prices of energy company bonds, particularly in the high yield category, those with below investment grade credit ratings cratered. As you can see from this chart of America’s benchmark, West Texas Intermediate Crude Oil, a barrel of oil was over one hundred dollars last summer before being cut by more than half earlier this year, falling to a six year low.

As several savvy WEALTHTRACK guests reminded us at the time, when oil rebounds in this cycle, which it inevitably will, it will move quickly. And so it has. Although it is still nowhere near last year’s highs.

Meanwhile oil investments remain under pressure.

According to this week’s guests the decline in energy related securities represents an opportunity for investors particularly in two areas. One is in what are known as energy Master Limited Partnerships, specifically those that invest in infrastructure companies, the pipelines and storage terminals which depend on the volume of oil and gas flows not their price. MLPs as they are known have been extremely popular with investors because they are legally required to pay out most of their income to investors and their distribution rates to investors have been very attractive in a low yield environment.

The other area is the bonds of energy companies, particularly exploration and production companies which have issued billions of dollars of debt in recent years to fund their production costs. Energy bonds makeup about 15% of all high yield debt.

Our guests are J. Gibson Cooper, Analyst and Portfolio Manager at Western Asset Management, one of the country’s largest fixed income managers and winner of the Morningstar Fixed Income Manager of the Year Award last year. Cooper oversees the high yield portfolios at Western. Chris Eades is Portfolio Manager of several Master Limited Partnership portfolios at ClearBridge investments, including the flagship, ClearBridge Energy MLP fund, a closed-end fund.

I began our discussion by asking them how much of a game changer the decline in oil prices has been.

GIBSON COOPER: Well, I think it’s a game changer really from the standpoint in our market and the fixed income market. It’s certainly been one of the largest contributors to the oversupply situation. So to the extent that the oil prices declined, that’s certainly taken a lot of wind out of the sails of the high-yield market in terms of providing capital to energy companies, in terms of activity levels that are declining. So it is a game changer, and we’re seeing a real rapid and aggressive response to the oil price within the companies that we research and invest in. So it is a game changer from the standpoint, at the company level. For the market overall, it is a little bit of a typical cycle we think. We think that it is not much different than other cycles we’ve experienced.

CONSUELO MACK: In oil and energy.

GIBSON COOPER: In oil and energy, and we are biased to a recovery in the price, but it will certainly take time.

CONSUELO MACK: So Chris, just a typical cycle? You’ve seen this before. Don’t get upset by it. Not shocking.

CHRIS EADES: We’ve done this many times. These are commodity markets. There’s going to be volatility. There’s going to be down markets. There’s going to be up markets, and this to me is, despite the severity of it in terms of the magnitude of the decline in the price of oil, it’s kind of a textbook commodity correction. The way the commodity markets work and certainly the way the oil market works is that if there is more supply than there is demand, that last barrel of oil that’s being unsold in the marketplace sets the price of oil for the entire market, and we had an oversupply last summer. Oil prices peaked in August, and obviously we’ve been in a big downdraft since then, but it’s natural given the oversupply that we had in the market, but I would also note that despite the fact that we’ve had this decline some of the self- correcting mechanisms that we typically see to the up side as well as to the down side are certainly a play. As Gib mentioned, we’ve seen a rather severe change in behavior from the E&P companies in terms of their drilling, in terms of their …

CONSUELO MACK: Exploration and production.

CHRIS EADES: Exactly. Exploration and production companies.

CONSUELO MACK: So you mean they’re cutting back on their drilling.

CHRIS EADES: Severely.

CONSUELO MACK: They’re firing people.

CHRIS EADES: In five or six months we’ve seen the number of rigs drilling for oil in the United States decline by 56 percent.

CONSUELO MACK: Wow. They move that quickly.

CHRIS EADES: It was huge. They do, they do, and that’s a short window, and that eventually is going to have an impact on supply which help tighten the market up a little bit, and then I think what gets lost on a lot of people right now is everyone keeps talking about the supply side of the equation. Demand’s responding as well. We are now seeing in the United States significant gasoline demand growth for the first time in five or six years. I read an article yesterday that indicated that global oil demand was estimated to be up around two percent in the month of February.

CONSUELO MACK: Is that a lot?

CHRIS EADES: It is. I mean typically most analysts right now are kind of thinking we’re going to have anywhere between one and maybe one and a quarter percent demand growth in 2015. If it in fact ends up being two, that alone would completely absorb the oversupply that we have in the market. I would have argued two months ago that it was going to take more than a couple of months for oil prices to recover. We’ve had a nice recovery in oil prices. We bottomed around 43. This afternoon or today rather they’re around 57. However, it’s not a question of if they’re going to recover. It’s a question of when they will, and it just takes a little bit of time for all these self-correcting mechanisms to work. So to me this is a textbook commodity correction.

CONSUELO MACK: Gib, one of the game changers that you mentioned to me in an earlier conversation was that there is no longer an oil cartel. Explain what you mean by that.

GIBSON COOPER: Well, for the first time in 50 plus years, even going back to the period of time when the Texas Railroad Commission controlled price and production and then later on OPEC was created, for the first time we don’t have really anybody in charge of the cartel in charge of the oil price. The market is in charge of that price.

CONSUELO MACK: What happened? Why aren’t they in charge?

GIBSON COOPER: Well, there’s a lot of answers to that question, and it’s probably all of the above. It serves geopolitical purposes. There’s intra-OPEC fighting. There’s issues with Iran and Russia, and then certainly they’ve studied U.S. shale, and they certainly acknowledge that it’s a real phenomenon. The U.S. is very efficient. We’re getting oil out of traditional oil basins more productively, and we’ve grown oil production three to four million barrels a day more over the last five years.

CONSUELO MACK: So we’re the new supplier, the big supplier on the block.

GIBSON COOPER: We are the new supplier. So for the time being we think the shale barrel is the marginal source of supply.

CONSUELO MACK: Right, and so has Saudi Arabia basically withdrawn involuntarily or voluntarily as the swing producer, or what’s their role going to be? I’m just trying to figure out what’s going to happen with oil prices with this dynamic going on.

GIBSON COOPER: They certainly voluntarily have given up on controlling price for the time being. I think we have to operate with that assumption going forward, and the Saudis will no longer serve to adjust their own production to meet the falloff in demand or excess supply. As Chris mentioned, we would agree that we don’t believe that the imbalance is that large.

CONSUELO MACK: Between supply and demand.

GIBSON COOPER: That’s right. That’s right.

CONSUELO MACK: Even with the U.S. being a new big producer.

GIBSON COOPER: That’s right. Globally the imbalance is probably running somewhere between a million and a million and a half barrels a day. As Chris mentioned, demand is better than forecast. The EIA and the IEA both have increased their global demand forecast this year by nearly a million barrels.

CONSUELO MACK: And therefore, so what should oil be trading at?

CHRIS EADES: In our view at ClearBridge, and I don’t think it’s dissimilar to what Gib’s going to say either …


CHRIS EADES: We think we need oil prices somewhere in the 75 to 80 dollar range just to have enough oil to meet normalized demand growth. Demand’s going to go up and down. It’s a little bit cyclical obviously, but on a long-run basis that’s the price we need, and the reality is … and this is why when oil was in the 40s a few weeks ago and even today with it in the 50s, global oil economics don’t work at 40 or 50 dollar oil. I mean on our math roughly two thirds of the world’s oil fields, it’s uneconomic to drill a new well in those fields with oil at 40 or 50 dollars a barrel.

CONSUELO MACK: So Gib, would you agree with what Chris is saying, that $70 a barrel, number one, is the price where oil should be and that eventually we’ll get there because of the dynamics of the market?

GIBSON COOPER: We would agree completely. Think of it this way. Chris mentioned the oil demand growing roughly a million barrels a year, but you also have depletion issues.


CONSUELO MACK: And depletion is?

GIBSON COOPER: Just natural declines of reservoirs. Lose pressure and there’s less oil produced the following year. So that alone is probably three to four million barrels a year. So you add that to the million barrels you need from new demand. So the world needs probably four to five million barrels per year more every year, and so we would agree with Chris. It’s not going to get it at $50. Not many basins work globally let alone in the United States at 50 to 60 dollars. Some do. The core of the best basins do work to some extent, but you won’t get the level of investment at current prices because you simply won’t have the cash flow, and the capital markets likely are not open to the extent they have been in the past to get that production. So we would agree that that marginal barrel probably needs to be supplied at around $70 or more, and it’ll take time to get there. We have seen a constructive tone developing over the last few months in the oil fields. Certainly Chris mentioned the decline in the rig count. It’s been very aggressive. I think it’s certainly running lower than I think the broad consensus had thought it would. Certainly seeing contraction in capital, capital markets being largely closed to raising capital to actually …

CONSUELO MACK: For energy companies.

GIBSON COOPER: Well, really for the E&P, for the exploration and production companies.

CONSUELO MACK: For the exploration and production companies.

GIBSON COOPER: To the extent that they can borrow money and issue equity to drill and produce more oil, that is significantly lower than where it was even six months ago. So basin level data is starting to cooperate. You’re starting to see the major shale basins in the United States, the Bakken and the Permian and the Eagle Ford begin to slow their growth rate. In fact, we think the Bakken and the Eagle Ford probably roll over and stop growing fairly soon and the Permian probably shortly thereafter.

CONSUELO MACK: What’s the impact on the debt issuers, the high-yield debt issuers in the exploration and production space which is sizable? Right?

GIBSON COOPER: That’s right. Like you started the session here, it’s been a game changer. Companies have relied on the capital markets, both they high-yield market, the investment grade market as well as the equity market.

CONSUELO MACK: Oh, it’s equity and debt.

GIBSON COOPER: Equity and debt has got us to where we are today by providing capital to grow and improve production by three or four million barrels a year. Without the capital markets, we wouldn’t be in this position. So today the markets are largely closed within the high-yield market. Some of the best…

CONSUELO MACK: And tell us about the high-yield market because energy is a sizable component of high-yield market.

GIBSON COOPER: It’s roughly around 15 percent of a 1.4 trillion high-yield market. So call it 200 billion.

CONSUELO MACK: So this decline in oil prices has really hit the high-yield market overall and especially the energy sector the high-yield market really hard.

GIBSON COOPER: That’s correct. Roughly half of our issuers are within the E&P space. Again really the theme within energy, within the high-yield energy space is simply capital preservation and liquidity preservation. The name of the game is not grow. Preserve capital. Preserve liquidity and make it to the other side of this cycle.

CONSUELO MACK: That’s the mode the companies are in.

GIBSON COOPER: That’s right. So management behavior is very important to us as fixed income investors. Chris mentioned it early on. Management teams are reacting very aggressively, more aggressively than I think consensus thought they would. They’re getting rewarded for not growing, for preserving capital, preserving enterprise value and waiting for oil prices to perhaps improve over the next couple of years, working off hedged cash flows, retaining capital, and for many companies that’s really prevented them from paying dividends, prevented them from buying stock back. And they’re getting rewarded for managing the balance sheet, and that’s why it’s particularly interesting for fixed income investors. It’s an interesting time to invest in the sector.

CONSUELO MACK: So the quality of management is going to matter a lot to you, and we’ll talk about that in a minute.

GIBSON COOPER: Absolutely.

CONSUELO MACK: So in the Master Limited Partnership space where you’re investing in MLPs, what’s the dynamic there? How have they responded? What difference does it make in the kind of companies that you invest in?

CHRIS EADES: It’s a very different world than what Gib is talking about for exploration and production companies on either the equity side or the debt side. I’m investing in the infrastructure, the pipelines, the processing plants, the storage terminals, those sorts of assets. Those assets by and large generate their cash flows irrespective of what the price of oil is or even what the price of natural gas is. What’s important for these assets is not the value of the commodity but the volume of the commodity moving through whatever infrastructure asset it is that we’re talking about. That being said, MLP stocks have been weak. I mean they haven’t had this severe decline that we saw in exploration and production companies nor as bad as what we saw in the oil field service companies but they still did decline. In peak to trough they were down around 20 some odd percent, and that would compare to exploration and production companies and service companies which were down around 50 percent. So not nearly as painful, but it shouldn’t have been as painful because the cash flows that these assets are generating are really largely unchanged. These are often regulated assets. These are assets that are backed up by long-term contracts, fee-based business models and not really dependent on the underlying price of oil and/or natural gas.

CONSUELO MACK: So has the distribution of cash which of course people invest in MLPs, the reason they’ve been such an attractive vehicle, is because they’re really great income streams. So how has that been affected?

CHRIS EADES: It actually has not shown up in the numbers yet. In fact, I was looking this morning.


CHRIS EADES: Well, it could, and I think it gets down to the duration of how long this oil price weakness lasts. I would argue that the rebound that we’ve seen to date has come quicker than I would have thought. If it’s sustained then I think fears about slowing distribution growth for MLPs are going to be proven wrong, but what we’re seeing right now, most of these companies have already reported their first quarter 2015 distribution rates. It was very solid, over 10 percent distribution growth on average year over year. That with an asset class that’s now yielding north of six percent, that’s where the total return proposition for owning MLPs is irrespective of people’s perceptions that these are quasi plays on oil prices or natural gas prices for that matter.

CONSUELO MACK: So should they be cutting back their distribution?

CHRIS EADES: No, no, no, no, no.

CONSUELO MACK: Protect their business or … ?

CHRIS EADES: I would not look for distribution cuts on average for the infrastructure- oriented MLP stocks that we invest in at ClearBridge. It is plausible that we could see a slowing of the growth rate but not that the growth rate goes negative. That’s a very important distinction that I think a lot of MLP investors …and this is still an asset class that is largely dominated by individual investors. They are fearful of cuts in income, not a slowing in the growth rate of income which is a very different dynamic of play.

CONSUELO MACK: And you’re saying there might be a slowdown in the growth in income, but there won’t be cuts in income.

CHRIS EADES: Not for infrastructure assets. Correct. For upstream assets, exploration and production assets?

CONSUELO MACK: Sure, that’s happening. Right?


CHRIS EADES: It’s happened many, many times and will likely continue, but for the infrastructure assets, the transportation-oriented assets, that has not happened. Let’s be honest, We’re almost nine months into this oil price correction, and we’re still seeing very healthy distribution growth, income growth from MLP companies.

CONSUELO MACK: Gib, so in the high-yield space, number one, are you more concerned about defaults among energy companies and their debt? And also is this more risky now, or is it more opportunistic?

GIBSON COOPER: Well, it’s certainly more risky, and I think that’s certainly evident by the higher yields in the marketplace for energy credit. Energy historically has traded well inside actually the high-yield market, typically around 100 basis points or one percent below the yield of the market. That’s reflective of its higher asset quality, typically higher ratings, lower default experience, and certainly hard assets underneath these companies. Today it trades around three percent higher than the overall market, and energy today yields roughly around eight and a half percent. So that’s reflective of absolutely a larger likely default experience. Back in December we felt that the market was overestimating the ultimate default rate these companies would experience over the next couple years and really underestimating management teams’ ability and to some extent the capital markets’ ability to enable companies to provide bridges and pull levers to create liquidity and preserve capital to get to the other side of the cycle. So yes, the yields are indicative of a higher default rate. We would certainly expect defaults to go up. We don’t think that’s a 2015 event. We think that’s more of a 2016 event if oil stays lower for longer.

CONSUELO MACK: And at Western Asset you actually think that the energy sector of the high-yield market is attractive. Right?

GIBSON COOPER: That’s correct. We do. We have broadly speaking in our funds, both institutional and retail, a healthy overweight to energy at the moment. A lot of that was put on in the last five months or so. Certainly we find that the spread difference between energy and the market today, within the market we can find very good opportunities at say in the seven to ten percent yield area that provide good current yield as well as potentially good total return opportunities. If we’re right in that, this is a cycle that will play out over the next couple of years, and oil will necessarily go back to where it needs to be to attract future supply growth.

CONSUELO MACK: And infrastructure companies? Do you think that they’re undervalued right now?

CHRIS EADES: Oh, certainly. We wiped out almost two years of gains in these stocks. We have a growth story that’s largely not impaired by this oil price environment. So I think it’s a very attractive environment, and we’ve actually been putting some money to work in this space. CONSUELO MACK: Final question to each of you; one investment for a long-term diversified portfolio. What would you have us all own some of? Gib?

GIBSON COOPER: I think one of the best stories that we’ve been researching quite a while is California Resources Corporation. Ticker is CRC, both the equity and the debt. It was spun out of Occidental Petroleum late last year, and it holds all the mature California oil assets in a single entity. This is a fantastic asset, world class asset, roughly 700 million barrels of reserves, long life, mature, not unconventional shale assets but conventional. So very low decline rate production which means relative to a lot of the high-yield shale producers, the company doesn’t really need to invest a lot over the next couple of years to maintain current production levels. So it’s very important because they can preserve capital, preserve liquidity and manage through a down cycle perhaps better than their higher decline rate brethren in some of the other shales in the United States.

CONSUELO MACK: Chris, what’s your one investment?

CHRIS EADES: Well, my one investment is going to be an infrastructure name, not surprisingly given what we’ve talked about thus far, and when I look at infrastructure companies, I really want three things. I want very strong balance sheets. I want companies that have strong growth opportunities both organically and perhaps even through acquisitions, and I want companies that have strong distribution growth or distribution coverage which again means that they’re generating more cash flow than they’re paying out, and the one name I’m going to highlight here is Plains All American. The ticker on that is PAA. It’s a company that yields around five and a half percent. It’s well positioned to deliver mid to high single-digit distribution growth not for one year but for multiple years down the road which position Plains to deliver total returns in excess of 10 percent for the foreseeable future. It’s a stock. It’s going to be volatile, but the assets that they’re invested in have stable cash flows, just the sort of thing that can be exploited given the weakness that we’ve seen in infrastructure stocks here over the last few months.

CONSUELO MACK: Thank you both for two very specific ideas which I know our viewers appreciate, and also thank you so much for being on WEALTHTRACK. Chris Eades from ClearBridge.

CHRIS EADES: Thank you.

CONSUELO MACK: And Gibson Cooper from Western Asset Management. Thanks for being here.


CHRIS EADES: Thank you.

CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action

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