My colleague Jeffrey Rosenberg discussed the economic implications of a drop in oil prices last month, pointing to how it could affect supply, demand, and U.S. monetary policy. I wanted to revisit this topic, as oil prices hit a five year low last week. An increase in the supply of oil (particularly from shale oil in the U.S.), and weaker worldwide demand, among other factors, have contributed to the significant price drop this year from over $107 a barrel in June down to its current level below $60. Recently, the market speculated about a potential production cut by OPEC to shore up the price, but failure to reach an agreement between the various member countries may mean that we should see low prices for some time.
Oil and the Energy Sector
Aside from paying less the next time you fill up your tank, the drop in oil has a powerful impact on oil and refining companies in the energy sector. At the very least, these entities will see their margins compressed. For example, say that it costs an oil drilling company $50 to extract each barrel of oil. When oil was trading at $100, their per-barrel margin was $50 ($100-$50). When prices fell to $60, that margin shrunk to $10. This has a significant impact on that firm's profitability and their long-term financial health.
If we look at the investment grade corporate bond market, we see that the energy sector makes up about 11% of the universe. Since July, the prices of bonds in this sector have fallen, and their yields have risen. This has resulted in the additional yield spread over Treasuries that these bonds pay to increase from 0.92% to 1.62%. This increase in spread reflects the higher level of credit risk that these issuers now carry.
Ways to Consider Playing the Energy Game
Given the changes in oil prices and the impact we are seeing in the corporate bond market, some investors may be wondering how to best manage their portfolio in this environment. One option is to manage energy exposure by using sector-specific funds to either dial up or down exposure to energy companies. iShares offers a suite of sector funds that give investors the ability to make a sector play in these types of situations. Here is a summary of the funds and their exposures.
Given this tool kit, here are three strategies you may want to consider:
- Avoid energy entirely. If you want to completely avoid the energy sector, you could consider the iShares Financials Bond ETF (NYSEARCA:MONY) or the iShares Utilities Bond ETF (NYSEARCA:AMPS), which only give you exposure to the financial and utilities sectors, respectively.
- Reduce energy exposure. If you want to reduce your overall exposure to the energy sector, you could think about overweighting the financial and utilities sectors using MONY and AMPS along with your core investment grade portfolio. For example, a core portfolio consisting of just the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD) would have 11% exposure to energy companies. A portfolio with 44% LQD, 28% MONY, and 28% AMPS would reduce that exposure by more than half, allowing you to have access to the other sectors in industrials while reducing your overall energy exposure.
- Take advantage of lower oil prices. The energy sector has priced in some of the impact of oil, and energy company bond prices have fallen. But if oil were to rebound these same bonds could rally. For investors who want to position for such a potential move, consider the iShares Industrials Bond ETF (NYSEARCA:ENGN), which currently has a 17% exposure to energy, the highest level of the investment grade credit funds.
There are likely a number of twists and turns in the road ahead for the oil market. Depending on how you think things will play out, sector-specific funds give you the flexibility to manage your portfolio exposures at a more granular level.
Read more articles from Seeking Alpha: