As energy companies focus more on balance-sheet strength and less on maximising growth, the sector is likely to become more attractive to credit investors.
Back when commodity prices were peaking, production volumes were arguably the key drivers of Exploration & Production (E&P) companies’ equity valuations. The underlying logic was simple: the faster the company grew production, the more barrels of oil it could sell at high prices. Expansion strategies were justified by high internal rates of return, exceeding those of returning capital to shareholders.
But this quest for growth weakened cash flows and stretched balance sheets. Seeking ever-more barrels, E&P companies borrowed frequently and heavily, leading to the energy sector becoming the largest constituent in the Global High Yield Index. As of November 2017, it accounted for about 15% of notional market capitalisation and about 22% of the market in terms of duration-times-spread.
Today, with oil and gas prices being lower, pump-priming growth provides less upside for E&P companies. Equity investors, disappointed with the diminishing returns from energy companies (see figure 1), now seem to favour capital discipline and free cash flow generation, which is rare among E&P businesses.
Figure 1. After a strong 2016, energy stocks have been lethargic this year
Source: Bloomberg as at November 2017.
Executive pay schemes typically incentivised absolute production growth as an explicit goal for E&P companies, which also explains why it dominated corporate strategies in the past. According to Goldman Sachs, of the 39 US upstream E&P companies covered by its equity research team, only seven had profitability metrics – such as growth per share adjusted for debt, or corporate return – in the management incentives disclosed in the 2016 proxy filings. This number dropped to four in 2017.
But this is beginning to change. Recently, some US E&P companies have taken steps to address compensation and profitability related concerns by introducing compensation metrics that do not incentivise absolute production growth at all costs. Instead, they focus on cash flows, which is welcome news for credit investors. These companies include:
This highlights the importance of governance on a company’s financial performance. We assess governance considerations into our credit analysis, and as a result some of our holdings include issuers whose incentives for executives are focused on improving profitability. These companies include Range Resources, Hess, Antero Resources and Marathon Oil.
Natural gas producers lead the way
This focus on cash flow and profitability is not only evident in revised incentives but also in the behaviour of companies. The 2018 guidance commentaries – especially those from natural gas producers – clearly show that cash flow is a priority. For example:
New cash-focused paradigm is a positive for credit
These announcements signal a change in the behaviour of E&P companies. They reflect the shifting preferences of equity holders from growth to value – which is clearly positive for credit investors.
Companies that spend within the limits of their cash flows typically have less-leveraged balance sheets and therefore lower risk profiles, which ultimately translates into tighter spreads. For example, after Range Resources announced its preliminary guidance for 2018, Moody’s upgraded the company’s Corporate Family Rating by one notch to Ba2. It also moved its outlook on the company to Positive, which drove unsecured bond spreads tighter. Marathon Oil, after announcing the developments described above and its stronger-than-expected results, has also outperformed the investment-grade market (see figure 2).
Figure 2. Range Resources and Marathon Oil: Credit investors like a good cash flow story
Source: BarclaysLive as at November 2017
Credit investors should feel energised
In the current environment of lower oil prices, credit investors should be encouraged by E&P companies’ focus on profitability at the expense of growth, and consequently benefit from greater capital discipline, lower risk profiles, tightening spreads and potentially stronger returns.