Lower oil prices and the selloff across the energy complex have cast a spotlight on corporate securities tied to “black gold.” From long-only credit holders to newly raised private equity funds, exposure to energy has become a priority for both value-seeking and yield-hungry investors. But as allocators consider ways to dial up energy-related risk, it is important to recognize that the effectiveness of traditional energy hedging instruments has changed dramatically over the past nine months.
The case for a high yield energy trade generally begins with the enticing potential of long exposures. That playbook relies on identifying deep value credits that have a fighting chance of staying current on debt payments by relying on cash cushions, balance sheet stability, oil hedging programs and a cost structure that can survive current or lower oil prices. But even experts on specific companies recognize the risk that oil price movements can become the primary driver of the ultimate return on energy-related positions. This inherent exposure to oil prices and related changes in expectations for global growth makes hedging a prudent consideration when building a high yield energy portfolio.
Today’s challenge to hedging comes down to the recent increase in basis risk1 and the substantial cost of buying left tail protection. Examining these tradeoffs increases the relative attractiveness of single name CDS as a hedging instrument.
- HY CDX – Unstable Basis. The liquidity and simplicity of CDX makes this hedging instrument a mainstay for many credit portfolios. However, when HY energy cash bonds sold off in 4Q14, CDX did not see a similar move. The spread between the two increased 500 bps over four months. This unstable basis makes it extremely difficult to determine an appropriate hedge ratio.
- Options on Oil Futures – Insufficient Bang for the Buck. The price of oil options has increased dramatically since the selloff began in mid-2014. One way to evaluate their ‘bang for the buck’ is to see how much left tail protection one could buy for a fixed cost. As of mid-May, spending 5% per year on buying out of the money oil puts only protects 10% of the portfolio in a $40 oil scenario. This compares to 179% of protection using options pricing levels from the summer of 2014. The price for buying convexity and left tail protection is just much greater in today’s environment due to changing supply dynamics in the U.S., political uncertainty in the Middle East and lack of clarity on global growth prospects.
- Oil Futures – Risk of the Tail Wagging the Dog. Hedging the risk of falling oil prices via shorting oil futures is a logical setup. However, in order to sufficiently protect a $10+ move in oil prices, the direct oil short would likely need to be sizeable. This amplifies the risk that returns become driven by movements in oil prices and global growth expectations. Furthermore, credit specialists may not be attuned to the nuances of trading oil futures.
- Single Name CDS – Relatively Attractive. Single name CDS lower but do not eliminate basis risk. Given that liquid CDS is tied to larger issuers, a potential company size mismatch is one key factor to account for. On the other hand, CDS allows one to identify companies that are more or less exposed to the same energy beta – from oil risk to geographic concentration. In addition, another benefit is that the same company-specific analytical expertise used to source long ideas can be applied to build a short book designed for hedging purposes.
The degree of effectiveness of traditional hedging instruments continues to evolve and monitoring existing and potential hedges for changing basis risks and increasing costs remains critical when constructing a high yield energy portfolio.
 Basis risk is the risk that an investment meant to hedge another exposure does not behave as anticipated, potentially creating excess losses.
 Assumes 5% annual spend equally split between 10% and 20% out of-the-money options on the September 2015 oil future. June 2014 implied volatility, prior to the oil selloff, was 20% vs. May 14, 2015 when it was approximately 35%. Assumes move from $61.5/bbl oil to $40/bbl.
Philip Wong, CQF, is an Associate Director at PAAMCO. His portfolio management responsibilities include sourcing and evaluating tactical and opportunistic investments. In addition, Philip serves as a member of the firm’s Strategy Allocation Committee, which identifies specific investment views that can impact portfolio positioning, risk and performance.
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