Market Bulletin. Oil plunges to $35 as OPEC fails to shift its course. 18 December In brief

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1 Market Bulletin 18 December 2015 Oil plunges to $35 as OPEC fails to shift its course In brief Oil prices reached fresh multi-year lows this week as domestic benchmark West Texas Intermediate (WTI) crude plunged to $35 per barrel (bbl) and international benchmark Brent crude fell to $37 per barrel (Exhibit 1). In this market bulletin we take a look at the recent OPEC action that is behind the slump in oil prices and explain why prices are likely to stay low for longer in Beyond the near term, sharp cuts to capex and the resulting underinvestment may lift oil prices over time, but to lower levels than before. Finally, we will explore the investment implications of this price behavior for energy stocks and bonds, as well as for the broader markets. In this environment, focus on high-quality fundamentals has mattered and should continue to matter for investors in energy stocks and bonds. Anastasia Amoroso, CFA Global Market Strategist Abigail B. Dwyer, CFA Market Analyst EXHIBIT 1: PRICE OF OIL WTI, NOMINAL PRICES, USD/BARREL $160 $140 $120 $100 $80 $60 $40 $20 Dec. 18, 2015: $35 $0 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 Source: Dow Jones, FactSet, J.P. Morgan Asset Management; unless otherwise stated, all data are as of 12/15/2015. The chart above and the charts, graphs and tables herein are for illustrative purposes only.

2 A bearish development for oil prices, though not unexpected OPEC announced on December 4 that it would maintain production at its current level of 31.5 million barrels per day (bpd). Prior to that statement, OPEC s production had been running above the quota of 30 million bpd for 18 consecutive months (Exhibit 2). The move effectively suspended the ceiling on OPEC production; the cartel said it would wait until its next meeting in June 2016 to confirm its output target. As we see it, the decision demonstrates that OPEC is determined to legitimize its right to produce at current levels or above and to compete for market share. Current levels may understate OPEC production. Of note, the new production level does not include oil production from Indonesia most recently at 823,000 bpd. The country rejoined OPEC on December 4, 2015 after exiting in Additionally, Iran vowed not to accept any curbs on its production until it restores about 1 million bpd of output after sanctions against it are lifted, which is expected in 1Q Commitment to maintain production at current levels could mean two things: either Saudi Arabia or others intend to quietly reduce their output levels to accommodate Iran s increase while protecting OPEC s overall output level (highly unlikely given budget pressures on many OPEC countries) or, more likely, actual output, once Iran sanctions are lifted, could be in excess of 31.5 million bpd. It has been quite clear for some time that OPEC s strategy is to compete for market share and place the burden of being the swing producer on someone else. This strategy has worked U.S. oil producers have had to shoulder the burden of reducing production (Exhibit 3). Oil prices to remain low and range-bound through 2016 Two key factors will likely keep oil prices at depressed levels for the near term: dollar strength and, more importantly, an oil supply vs. demand imbalance. EXHIBIT 2: OPEC CRUDE OIL PRODUCTION MILLIONS OF BARRELS PER DAY 33, OPEC meeting 32,500 32,000 31,500 31,000 30,500 30,000 29,500 29,000 OPEC quota: 30m barrels/day 28,500 Jul '13 Nov '13 Mar '14 Jul '14 Nov '14 Mar '15 Jul '15 Nov '15 Source: Bloomberg, OPEC, J.P. Morgan Asset Management; data are as of 12/15/2015. EXHIBIT 3: U.S. CRUDE OIL PRODUCTION MILLIONS OF BARRELS PER DAY OPEC meeting Jul '13 Nov '13 Mar '14 Jul '14 Nov '14 Mar '15 Jul '15 Nov '15 Source: Bloomberg, EIA, J.P. Morgan Asset Management. October and November statistics from the end of the monthly Weekly Petroleum Status Reports; data are as of 12/15/ OIL PLUNGES TO $35 AS OPEC FAILS TO SHIFT ITS COURSE

3 Since oil is denominated in U.S. dollars, as the dollar strengthens, oil prices tend to decline. The dollar appreciated by 12% in the past year. The Federal Reserve raised interest rates on December 16 while other developed country central banks are still in easing mode. Higher U.S. rates may cause the dollar s strength to persist as previously anticipated policy divergence finally becomes reality. However, there is more to oil weakness than dollar strength. As long as global oil production continues to outpace oil consumption (as it has since 2014 and is expected to do through 2016), inventories will continue to expand, pushing oil prices lower (Exhibit 4). For now, the buildup in inventories continues because even though U.S. production is starting to decline, OPEC s production is ramping up and Iranian sanctions relief could serve to depress prices further over the near term. EXHIBIT 4: CHANGE IN PRODUCTION AND CONSUMPTION OF OIL PRODUCTION, CONSUMPTION AND INVENTORIES, MILLIONS OF BARRELS PER DAY Source: EIA, J.P. Morgan Asset Management; data are as of 11/30/2015. Beyond the near term, an oil price rise? Looking past producers near-term pain from oversupply, in time, deep cuts to energy capital expenditures and the resulting underinvestment in replacement production could lead to outright declines in U.S. oil production. Over the past year, rig counts are down by 66% (Exhibit 5). That is starting to lead to declines in production because the typical decline rate of a shale well is rather steep; already, over the past few months, the new addition to production from wells that are being drilled (of which there are now far fewer than before) is not enough to offset the decline in production from existing wells (Exhibit 6). EXHIBIT 5: U.S. OIL RIG COUNT NUMBER OF ACTIVE RIGS 1,700 1,500 1,300 1, Dec '12 Jun '13 Dec '13 Jun '14 Dec '14 Jun '15 Source: Baker Hughes, J.P. Morgan Asset Management; data are as of 12/15/2015. This trend, if it continues, should lead to lower oil production next year. Indeed, the Energy Information Agency (EIA) estimates that U.S. production will decline to 8.8 million bpd in 2016 from 9.3 million this year. This could result in a more balanced market over time, especially as demand rises. The EIA expects global demand for oil and other liquids to rise by 1.4 million bpd in 2016 and WTI crude prices to rise toward $51 per barrel toward the end of EXHIBIT 6: NET CHANGE IN U.S. OIL PRODUCTION NET CHANGE IN MONTHLY PRODUCTION (NEW WELLS NET OF LEGACY DECLINES), THOUSANDS OF BARRELS PER DAY Jun '14 Sep '14 Dec '14 Mar '15 Jun '15 Sep '15 Dec '15 Increasing prod. Decreasing prod. Source: EIA, J.P. Morgan Asset Management; data are as of 12/15/2015. J.P. MORGAN ASSET MANAGEMENT 3

4 What does this mean for energy stocks and bonds? The answer is fundamentals will matter. This has proven true over the past year for energy stock and bond performance and will likely determine which companies best weather the storm until supply and demand move back into balance and the price of crude begins to rise. ENERGY STOCKS FOCUS ON LARGER AND STRONGER Predictably, energy stocks are leading on the downside in the final month of 2015 and have been underperforming the broader market for most of the year. However, company size and balance sheet strength have mattered a great deal. This can be seen in the performance of large energy companies in the S&P 500 relative to the smaller energy companies in the S&P 600 (Exhibit 7). More liquidity-challenged and balance-sheet-constrained small caps fared far worse. Similarly, comparison of the performance of an equalcap-weighted index (represented by the SPDR S&P Oil & Gas E&P ETF) vs. one with weights based on fundamentals (the Powershares Dynamic Energy E&P ETF) also indicates that energy companies with greater earnings diversification and stronger balance sheets have outperformed (Exhibit 8). EXHIBIT 7: SMALL CAP AND LARGE CAP ENERGY PERFORMANCE PRICE, INDEXED TO 100 ON 12/31/ % % S&P 500 S&P 500 Energy 60-47% S&P 600 Energy Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: FactSet, J.P. Morgan Asset Management, Standard & Poor s; data are as of 12/15/2015. EXHIBIT 8: ENERGY SECTOR VERSUS ENERGY SECTOR FUNDAMENTALS PERFORMANCE PRICE, INDEXED TO 100 ON 12/31/ % YTD 85 Dynamic Energy E&P ETF 75 SPDR Oil & Gas E&P ETF 65-37% YTD 55 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: Bloomberg, Invesco, J.P. Morgan Asset Management; data are as of 12/15/2015. For companies with the balance sheet strength to ride out lower for longer oil prices, the silver lining is reduced production costs. Since late 2014, per unit drilling costs have fallen approximately 25%, thanks to technological and productivity improvements as well as successful cost renegotiations with oil service providers. The breakeven cost of drilling a well used to be $60 per barrel of oil, but now, with cost efficiencies, $45 is the new $60. Keep in mind, however, that breakeven costs vary greatly across different wells and shale play fields and some wells may have breakeven costs below $45, pushing fundamental price support still lower. While lower incremental costs of production mean fundamental support for oil at even lower levels, cost reductions also mean that if and when oil prices pick up, companies should be able to regain profitability at a much lower threshold. In re-establishing profitability and stability, the focus will likely be on scale as well as costs. Given the amount of distress among producers with high yield debt, defaults, restructuring and M&A are likely on the horizon. We therefore focus on the stocks of large energy companies with low debt, large scale (or the ability to gain it) and balance sheet strength. 4 OIL PLUNGES TO $35 AS OPEC FAILS TO SHIFT ITS COURSE

5 ENERGY BONDS A SIMILAR STORY OF SIZE AND STRENGTH The story of larger and stronger companies outperformance holds true for energy bonds as well. The spreads on U.S. energy investment grade bonds widened this year, but far less than the spreads for energy high yield bonds (Exhibit 9). EXHIBIT 9: HIGH YIELD AND INVESTMENT GRADE SPREADS BASIS POINTS, SPREAD TO WORST High yield energy spread 150 Investment grade energy spread Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: J.P. Morgan Economic Research, J.P. Morgan Asset Management; data are as of 12/15/2015. This is because energy high yield issuers have higher leverage ratios (measured by debt to EBITDA) than energy investment grade issuers (3.5x vs. 2.2x, respectively) and their smaller scale and less diverse operations put cash flow in greater jeopardy. Among distressed bonds (trading at 50% of par value or below) in the JPMorgan Domestic High Yield index, 55% are energy bonds. What is keeping these producers afloat is access to bank financing and hedging programs. However, these lifelines are not guaranteed. First, on a semi-annual basis, banks redetermine the size of a credit line based on the value of oil reserves, which are in turn based on the price of oil. While redetermination in the fall did not create too much turmoil, spring redeterminations may be less favorable, especially if oil prices remain this low. Secondly, the hedging programs that are in place and are sizable for 2016 are much less sizable in Moreover, while some producers have hedging ratios in the 60%-80% range, the weighted average hedging percentage is only 15% for This means that a lot more defaults are likely to follow in 2016, and the energy default rate could rise from 4.1%, as of November 30, 2015, to 10% in 2016 and 20% in 2017 (Exhibit 10). EXHIBIT 10: HIGH YIELD ENERGY SECTOR DEFAULT RATE PERCENTAGE 24% JPM forecast 19% 14% 9% 4% -1% '10 '11 '12 '13 '14 '15 '16 '17 Source: J.P. Morgan Economic Research, J.P. Morgan Asset Management; data are as of 12/15/2015. The yield on energy high yield bonds has reached 15% and while many of these bonds may default, not all of them will. This distress and a surge in yields within the energy sector will no doubt present an opportunity for investors with experience and expertise in distressed investing and for managers focused on quality fundamentals. Defaults ex-commodities, however, are 1.5% this year and are expected to stay low at 1.5% in 2016, below the long-term average of 3.6%, while spreads on high yield bonds ex-commodities widened this year to 645 bps. This could present an opportunity for investors in non-commodity high yield sectors where solid economic growth and low expected defaults could result in spread tightening (Exhibit 11). J.P. MORGAN ASSET MANAGEMENT 5

6 EXHIBIT 11: HIGH YIELD ENERGY AND HIGH YIELD EX-ENERGY, METALS & MINING SPREADS BASIS POINTS, SPREAD TO WORST High yield energy 1150 High yield ex-energy/metals & mining Dec '13 Jun '14 Dec '14 Jun '15 Source: J.P. Morgan Economic Research, J.P. Morgan Asset Management; data are as of 12/15/ EXHIBIT 12: S&P 500 PERFORMANCE BY SUB-SECTOR MONTHLY, INDEXED TO 100 ON 12/31/ S&P 500 Auto retail Internet retailers Restaurants 85 Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Source: J.P. Morgan Asset Management, FactSet, Standard & Poor s; data are as of 12/15/2015. What hurts some, benefits many others The low price of oil is a painful reality for the energy sector, but a welcome relief for the U.S. consumer. Over the course of this year, the consumption component of GDP has remained solid and retail sales, while not accelerating sharply, have been grinding higher. According to a recent report from JPM Institute that looked at consumption patterns of 25 million credit card accounts, consumers have been spending their gasoline savings. And while this is not translating into a major pop in overall retail sales, it has resulted in outperformance for certain sectors of the markets (Exhibit 12). Consumers have been spending (using their gas savings or other sources), but doing so selectively. Oil prices are likely to stay low into 2016, providing further relief for consumers. This, along with expectations of higher wages and the prospect of rising rates (assuming consumers are encouraged to spend ahead of an increase in borrowing costs), could again support and accelerate overall consumption next year. The takeaway for investors, then, is one borrowed from U.S. consumers: Do deploy your investment dollars next year, but do so selectively. Investment implications Within the energy sector, we continue to favor the equity and debt of issuers with high-quality fundamentals. Low debt, large scale and balance sheet and cash flow strength helped support the relative performance of these stocks and bonds over the past year, even as oil prices plunged 42%. The same strengths should help them persevere in a period of range-bound, though somewhat higher, oil prices that we believe will persist through yearend Ultimately, as supply-demand imbalances correct and prices begin to rise, these companies can benefit from industry reductions in production costs, leading to improved profitability at a lower oil price threshold. In energy bonds, where yields have reached 15%, many of these bonds may default, but not all of them will. This should present an opportunity for investors with experience and expertise in distressed investing and for managers focused on quality fundamentals. The key message for energy investors in 2016 is to deploy investment dollars, but to do so selectively. 6 OIL PLUNGES TO $35 AS OPEC FAILS TO SHIFT ITS COURSE

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