One area in which there has been a real change in fundamentals is in the energy market. West Texas Intermediate (the U.S. benchmark for oil prices) recently fell to the mid $40s in the middle of January and many market participants see potential for a further slide. Previous $100/barrel oil masked many of the inefficiencies of many oil producers. In the long run, however, a lower oil price will likely weed out inefficient producers and delay or cancel projects that are less efficient. This should help increase efficiency into the exploration and production market and create long and short opportunities.
Whether one believes that the drop in oil prices is driven by an increase in supply (e.g., the U.S. shale revolution) or a decrease in demand (coming from slower growth worldwide), or both, what we certainly know for sure is that oil prices have fallen quickly and considerably. This has prompted investors to reduce their exposure to energy and anything that is even tangentially related to energy, including parts of the transportation sector such as shipping, industries where energy is an input such as petrochemicals, and consumer discretionary sectors such as retailers and leisure providers.
Many potential opportunities have surfaced in the energy sector. For example, in the high-yield bond market, there has been a dramatic divergence between the energy names and the rest of the index. In 2014, energy names posted a -7.3% return for the year vs. 1.83% for the overall high-yield corporate index, a dispersion of more than 9% in performance.
Nonetheless, a note of caution is warranted for bargain hunters in this sector. Capital structure matters, and matters more than ever. Firms that are highly levered will be hurt the most as the market sell-off hits the top line and potentially the bottom line as well. Energy names have been some of the most prodigious issuers of high-yield bonds, tapping into a yield-hungry market. As a result, energy has become a large slice of credit indexes, anywhere from 16% to 20% for key indexes. Some key differentiators among energy sector opportunities include differences among fixed-price contracts, geological exposure and ability to be the low cost producer as well as idiosyncratic factors such as which assets are mission critical (i.e., the company will do everything in its power before defaulting on that particular asset). Similarly, those who are exposed to marginal/swing capacity are likely to be vulnerable.
Opportunities also exist in other sectors that benefit from lower energy price, such as the consumer and transportation sectors. For example, in the consumer sector, there are opportunities in goods for which demand will increase on the back of consumer savings, such as retailers and restaurants, thanks to lower oil prices.