The energy sector as a whole has been the weakest-performing global high-yield sector. Our corporate credit team delves into the challenges facing high-yield energy issuers today.
- A large number of issuers in the energy sector have suffered year-to-date declines of 40% to 90% in their bonds’ total return, and the energy sector as a whole has been the weakest-performing global high-yield sector, with a total return in US dollars of 6.0% against a high-yield average of 10.4%.¹
- The driving factor is company-specific – not all energy companies are in decline – though with a common theme: the tradition of operating energy businesses with no free cash flow and high leverage is running afoul of an increasingly skeptical market.
- We expect the universe of high-yield energy issuers to continue to shrink as companies combine to bolster their returns and to become more relevant to investors, and thus believe investors should treat index-tracking products with commensurate skepticism.
Peak oil – the theory that there would be a point in time when the maximum rate of oil extraction was reached – was first theorised by geologist M. King Hubbert. His prediction that US oil production would peak around 1970 seemed convincing for a time, until hydraulic fracturing in recent years caused supply to rebound and surpass previous records. Globally, the world is producing more oil than ever. What Hubbert overlooked, however, was whether we are heading for peak demand. Energy is in a transition and as investors we need to recognise this.
Within the first eight months of the year, energy was the weakest- performing global high-yield sector, with a total return in US dollars of 6.0% against a high-yield average of 10.4%. What is more, a large number of issuers suffered declines of 40% to 90% in their bonds’ year-to-date total return.¹
Company-specific factors driving returns
A challenging backdrop that includes soft commodity prices, increasing regulatory pressure and a trend toward cleaner fuels are all contributing to the malaise. But the driving factor is company-specific – not all energy companies are in decline – though with a common theme: the tradition of operating energy businesses with no free cash flow and high leverage is running afoul of an increasingly skeptical market.
Energy companies are, ultimately, operating in a commoditised sector, so are typically “price takers.” They cannot demand the earth provide their raw goods at a lower rate, and the price of their finished goods are determined in a highly efficient global market. This makes their earnings more volatile (in line with the volatility of commodity prices), and their profitability more dependent on the quality of their assets and the aptitude of their management. In the past decade, too many energy-related companies have produced meager profits. And the energy sector has a long history of being more focused on their growth than their free cash flow. Finally, as issuers in the high-yield market, they are typically highly leveraged companies. It is a toxic (pun intended) combination.
Yet that does not mean that all energy companies should be avoided. As with any type of investing – selectivity is key. Companies with a good expected production profile, low cost structure and proven management exhibit positive characteristics. For example, Aker BP, a Norwegian oil company, rated Ba1 by Moody’s and BB+ by S&P has had recent success with discoveries and a field in which it has a stake is set to come onstream. This gives visibility to the production pipeline, and is one of the reasons Fitch, the credit rating agency, has given the company an investment grade credit rating.
Worst-performing bonds in the global high-yield bond index
A large number of energy issuers suffered declines of 40% to 90% in their bonds’ year-to-date total return.
Source: Factset, ICE BofAML, Janus Henderson Investors, year to date as of 31 August 2019.
Notes: Index used is the ICE BofAML Global High Yield Constrained Index (HW0C), total returns in US dollars. Past performance is no guide to future performance. References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security.
Janus Henderson makes no representation as to whether any illustration/example mentioned is now or was ever held in any portfolio. Illustrations are only for the limited purpose of analysing general market or economic conditions and demonstrating the research process. References to specific securities should not be construed as recommendations to buy, sell or hold any security, or as an indication of holdings.
There are structural changes afoot within the energy sector. Some integrated oil companies and oil majors are moving to short cycle crude projects such as US shale basins (the Permian is a particular focus for ExxonMobil and Occidental) and away from longer duration crude projects with higher up-front costs, such as deepwater wells. Others are seeking greater exposure to gas assets and liquefied natural gas (LNG), for example, the purchase of BG Group by Royal Dutch Shell was primarily to lift its gas exposure.
Utilities have generally preferred gas in the past decade. It has helped that gas prices have been falling in the U.S., but the primary driver globally has been gas being viewed as a "bridge" between reducing reliance on carbon-intensive coal power generation and the move to scaling up renewable energy. Gas emits less C0₂ during power generation and fewer particulates than oil and coal and thus the transition is part of a steady, structural trend toward cleaner fuels. What is more, gas can be brought on line quickly, which is important as the more erratic renewable energy sources feed into the grid and become a larger part of the energy mix. That said, rapidly declining renewables prices mean some commentators are calling into question the longevity of the bridge. There is even a blurring of the lines between energy companies and utilities, for example, Royal Dutch Shell, through Shell Energy in the UK, is supplying electricity generated by renewables direct to households.
What is clear is that the regulatory environment is turning more aggressive and the political atmosphere outside of the US is becoming increasingly green. European regulations taking effect in January 2020 will require carmakers to lower average C0₂ from their new cars to 95g per kilometer or risk a fine, hence the surge in so many electric and hybrid models from European carmakers for the coming year. We do not expect the shift to electric vehicles to happen overnight (although Norway is leading the march) but the direction of travel is becoming clear and could one day lead to stranded hydrocarbons as demand for oil fades. The timeline for monetising reserves therefore becomes an ever more important consideration.
Oil and natural gas pricing
Cleaner credentials and a declining price are making gas the fuel of choice.
Source: World Bank Commodity Price Data, August 2004 to August 2019
Notes: Based on monthly prices. Crude oil represents West Texas Intermediate (WTI). MMBtu is metric million British thermal units.
In fact, regulation is an area where a strong global research team can share information and come to more informed decisions. The International Maritime Organisation (IMO) 2020 regulation is a case in point. From 1 January 2020, the updated MARPOL Annex VI regulation, to give it its full name, will limit sulphur content in marine bunker fuel to 0.5%, down from a current level of 3.5%. This applies to vessels operating outside Emission Control Areas, where sulphur content remains limited to 0.1%. Ship owners have three choices: use cleaner compliant fuels, buy more expensive low sulphur fuel or invest in exhaust gas cleaning systems (so-called scrubbers).
This regulation is clearly beneficial to energy companies that produce or refine low sulphur fuel or compliant marine gas oil, but it also has cost implications for the transport sector. The costs of implementing IMO 2020, coupled with a slowdown in global trade caused by the US-China trade war, mean the prospects for shipping companies look weak and raise question marks over free-cash-flow generation in that sector.
The future of the HY energy sector
Despite the dramatic collapse in some corporate bonds, the energy sector has seen harder times, as evidenced in the upgrade/downgrade ratio. Compared to the carnage in 2015 and 2016, the first half of 2019 looks fairly average, although the improvement of recent years has deteriorated. Recently announced mergers of equals have resulted in favorable responses from the rating agencies for high-yield companies, including positive watches from both Moody’s and Standard & Poor's for PDC Energy’s (B1/BB-) merger with fellow Denver- Julesberg basin producer SRC Energy (B3/B+).
Upgrades and downgrades in the energy sector
Downgrades outpace upgrades in the first half of 2019.
Source: Moody’s, as of 5 July 2019
The spike in energy prices caused by the attacks on Aramco facilities in Saudi Arabia may give a short-term fillip to energy companies profits and the aim to reduce leverage among high yield energy companies is to be welcomed but this needs to be weighed against evidence of more shareholder-friendly financial policy or mergers and acquisitions among investment-grade rated integrated oil and gas companies, the impacts (good and bad) of consolidation on both investment-grade and high-yield rated energy companies, and some poor pricing power in oil field services.
There are signs that management of energy-related companies are already adapting. We are seeing changes in executive compensation plans that incentivise managers to value better cash flow, lower debt (leverage) and higher corporate returns over company growth. For example, at this year’s annual shareholder meeting, Range Resources adopted a new executive incentive compensation metric of "absolute debt reduction" – which is additive to their current debt/ EBITDAX² performance hurdle.
Nevertheless, we expect the universe of high-yield energy issuers to continue to shrink as companies combine to become more relevant to investors or seek to improve corporate level returns via cost synergies. In 2019, three mergers involving high-yield issuers in the energy sector have been announced, including Comstock Resources’ acquisition of Covey Park Energy, Callon Petroleum Company’s acquisition of Carrizo Oil & Gas (pending shareholder approval), as well as the aforementioned PDC Energy and SRC Energy merger of equals
(pending shareholder approval).
What are the lessons for fixed income investors?
The world is changing, and the energy sector is in the thick of that change. Whether that change is driven by regulators, consumers, investors, or a drive to remain relevant, energy companies will continue to evolve. Investors should remain mindful of these larger trends, and not lose sight of the intersections of industries, even as diverse as shipping and energy.
Yet credit markets, like equity markets, are made up of company-specific risks. While companies within an asset market (like global high yield) are usually correlated, and companies within an industry are typically more highly correlated, the risk of a corporate default often originates within its walls. We believe investors should treat index-tracking products with commensurate skepticism. Name-by-name fundamental research may reveal less obvious benefits when one company does slightly better than another, but within fixed income, where returns are asymmetric, such research combined with active management is paramount to avoiding the losses that can have such an impact on portfolio returns.
1 Source: FactSet, ICE BofAML Global High-Yield Constrained Index, total return in U.S. dollars, 31 December 2018 to 31 August 2019.
2 EBITDAX= earnings before interest, taxes, depreciation, amortisation and exploration expense.
Bond ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
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