Oil Can’t Wait for 2021

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Real Assets Spotlight

by John LaForge, Head of Global Real Asset Strategy

“Prosperity is a great teacher; adversity is greater.”  — William Hazlitt

• We expect oil prices to be range-bound for the rest of 2020.
• 2021 may be a different story, however, as supply could become an issue.

2021 is almost here! Or better said, 2020 is fortunately coming to a close. No asset wants 2020 to end more than U.S. oil. To say that this year has been ugly would be woefully underestimating oil’s plight. No major asset can claim that it has been damaged more by the coronavirus pandemic, which is quite the distinction. On April 20, the main U.S. oil benchmark price, West Texas Intermediate (WTI), closed the day at -$37.63 (per barrel). This can be seen in Chart 1. In the history of U.S. oil, which dates to 1859, never have we seen such a thing.

Since April, WTI oil prices have acted more rationally, and they have bounced to the levels that best reflect current supply and demand. For WTI, that balance is near $40 per barrel, while for Brent, it is closer to $45.

As for oil’s move into year-end, our forecast is sideways. Our 2020 year-end target ranges are $35-$45 per barrel for WTI oil, and $40-$50 per barrel for Brent. They have been the same since March, and we’re not inclined to change them now. Global demand has been recovering — but not fast enough to warrant much higher prices. And the world has plenty of supply available at these levels.

Chart 1. WTI Oil

Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 3, 1984 - September 9, 2020. WTI = West Texas Intermediate oil. Past performance is not a guarantee of future results.

2021 could be a different story, though. Supplies are plentiful today, but if prices continue to languish under the $45 level for the remainder of 2020, the supply side could clear up quickly.

The U.S. could very well lead the way in 2021 oil-supply reductions as it is one of the world’s highest-cost producers. Average breakeven costs for oil in the major U.S. shale basins are approximately $40 per barrel. Prices under $40 tend to reduce production — as we saw this spring and summer. U.S. oil production began the year near 13 million barrels per day, when WTI traded between $50 and $60. Production has since dropped below 10 million barrels per day (Chart 2, dark purple line). Much of this production is of the lower-cost variety. It will likely not last forever. And remember, historically, U.S. shale wells deplete notoriously fast. U.S. oil producers eventually will likely have to turn to their cache of drilled but uncompleted wells (Chart 2, orange line). These wells are not being produced today for a reason. That reason is cost. These are the higher-cost wells that generally require higher oil prices to complete.

We believe the longer oil prices stay below $45 in 2020, the higher the likelihood that 2021 could see oil prices of $50 or more, if not $55 or more, to entice increased production. In September 2020, it’s likely too early to position for this yet. It is a trend worth watching, though, as oil exits its ugliest year — ever.

Chart 2. Drilled but uncompleted wells versus production

Sources: Bloomberg, Energy Information Administration (EIA), Wells Fargo Investment Institute. Monthly data: January 31, 2014 – August 31, 2020.

Equities

by Ken Johnson, CFA, Investment Strategy Analyst

• We continue to see structural earnings headwinds for the Energy sector, and we retain our most unfavorable view of this sector.
• Energy stocks typically offer investors higher-than-average dividend yields. Yet, weakening cash flows pose risk to future dividends for some firms in the Energy space.

No good news for Energy stocks 

The S&P 500 Energy sector is up 43.2% since the March 23 trough through September 9, but the good news seems to end there. Returns have been negative for 1-year, 5-year, 10-year, 20-year, and year-to-date (YTD) periods through September 9, 2020. Performance has been negatively impacted by lower oil prices, resulting from a supply/demand imbalance.

Since the early 1980s, WTI’s oil price has crashed by 40% or more 10 different times. Between 2014 and 2016, WTI oil plunged from $107 per barrel to $26. On September 10, WTI oil stood at approximately $38 per barrel. The average breakeven price for U.S. shale producers is $40 per barrel of oil, so today’s prices may present sustainability risk for many firms.

The Energy sector has been undergoing consolidation as companies seek to adjust to lower oil prices. Still, these persistently low oil prices have weakened Energy companies’ cash flow generation capabilities, further comprising many firms’ already poor balance sheets and jeopardizing future dividends for some companies.

We believe that the Energy sector will see more consolidation before it can fully recover. We expect to see more staff downsizing and a reduction in capital spending. Additionally, mergers, acquisitions, and bankruptcies have increased this sector’s concentration risk. Today, two firms make up approximately 50% of the S&P 500 Energy sector’s market capitalization. Going forward, we expect these factors to lead to more volatility. We retain our most unfavorable Energy sector view.

Energy stocks have underperformed the S&P 500 Index as oil prices have declined 

Sources: Wells Fargo Investment Institute, Bloomberg, September 9, 2020. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Fixed Income

by Luis Alvarado, Investment Strategy Analyst

• There are embedded risks in this fixed-income class, particularly since they are not part of the Federal Reserve’s (Fed) specifically supported debt classes and because we expect higher default rates in the near term.
• We prefer to allocate assets to high-yield corporate bonds and other fixed-income classes with above-average yield potential.

Leveraged loans—caution warranted

Leveraged loans are senior secured loans made to companies that have a below-investment-grade rating, often outside the banking sector. Collateralized loan obligations (CLOs) are established to hold and manage pools of these loans. A recent Federal Reserve (Fed) report offered a snapshot of the U.S. CLO investor base. It concluded that institutional investors own nearly 80% of U.S. CLOs outstanding. Insurance companies lead with 33%, while other nonfinancial entities and households own 8.1%.

It also is interesting to see how each of these investors allocates exposure to the CLO tranches by credit quality: senior notes (lowest risk in the space), mezzanine and junior notes (moderate risk), and equity notes (highest risk). For institutional investors, approximately 50% or more is in senior notes; equity note exposure ranges from 1% to 13%. Nonfinancial entities and households had 38.8% of exposure in senior notes and 20% in equity notes. Although these are estimates, this suggests that some individual investors may have sizeable exposure to riskier CLO tranches.

Although leveraged-loan returns have been keeping pace with high-yield-corporate bond returns this quarter, we see several key risks in this fixed-income class, particularly since these loans are not part of the Fed’s supported debt classes and because we expect higher default rates to materialize toward year-end.

U.S. leveraged loan default rates 

Sources: S&P Leveraged Commentary and Data, August 31, 2020. Monthly data: August 2015 - August 2020.

Alternatives

by Justin Lenarcic, Senior Global Alternative Investment Strategist 

• Convertible bond arbitrage has faced a challenging decade, but we see early signs of a resurgence.
• Trends in net issuance recently have accelerated sharply as volatility has risen. We believe that these trends mean that the environment for convertible arbitrage is as attractive as it has been in years.

Rising from the ashes — convertible bond arbitrage

In recent years, convertible bond arbitrage has been an overlooked strategy — believed to be a remnant of the late-1990s and early 2000s “golden age” for hedge funds. Since the global financial crisis, net convertible bond issuance has been relatively low by historical standards (see chart below). When this was combined with muted equity volatility and low interest rates, it drastically diminished the opportunity set for convertible bond arbitrage. In fact, over the past decade, many of the dedicated convertible arbitrage funds have either morphed into ubiquitous “opportunistic credit” funds or been absorbed into multi-strategy firms. But we sense a rebirth for this unique strategy, driven by a potent combination of significantly higher convertible bond issuance this year and our expectation for a gradual shift into an environment with higher credit and equity volatility.

Year to date through August 31, the HFRI Relative Value: Fixed Income Convertible Arbitrage Index is up 5.2%, outperforming the Bloomberg Barclays U.S. Corporate High Yield Index by 3.5%. With many companies needing to repair pandemic-related balance sheet damage, we recently have seen significant acceleration in convertible bond issuance. We believe many of these bonds are priced at attractive levels, given the urgency for the issuers to raise capital. Further, spreads for many small- and mid-cap issuers remain wider than similarly rated investment-grade or high-yield bonds.

For the remainder of this year and next, we expect convertible bond arbitrage to benefit from further credit-spread tightening, an increase in equity market volatility, and the potential for issuers to convert debt to equity, should equity markets continue to appreciate significantly.

Convertible bond net issuance is returning to early 2000s levels

Sources: Bank of America Merrill Lynch, Wells Fargo Investment Institute. Data is as of August 31, 2020.

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