The high-yield energy sector underperformed in the final quarter of last year as oil prices sold off. Amid this volatility, how can credit investors find stable outperformers?
Volatility in oil markets has increased in recent months. By the end of September 2018, oil prices had risen by 23% since the beginning of the year, only to fall dramatically in the final quarter. This month, West Texas Intermediate (WTI) crude oil has traded in a range of $46-$54 per barrel.
Concerns over the slowing world economy and fears of increasing oil supply from North America have arguably been the key drivers of the correction, leading the energy sector of the high-yield market to significantly underperform global credit markets in the last few months (see figure 1). Such a severe move presents challenges for investors – but also opportunities.
Figure 1. Running low: the high-yield energy sector has underperformed the global market since January 2018
Source: Bloomberg, ICE BofAML Indices as at January 2019.
E&P issuers come with credit risk
When oil prices boomed earlier in the decade, many exploration and production (E&P) companies borrowed heavily in order to maximise production. But as prices declined, a shift towards a greater focus on stronger cash flows was soon underway, and has continued.
In our view, most high-yield E&P companies remain in a transition period, with capital-expenditure spending continuing to exceed cash flows. Simultaneously, lower rated and higher cost oil and gas producers exposes investors to elevated credit risks – especially if oil prices remain low for an extended period.
This limits the opportunity spectrum, but there remain attractive instruments issued by companies firmly aligned with the credit-friendly trend of strengthening cash flows.
Tapping opportunities in the midstream
Look beyond ‘upstream’ E&P companies towards ‘midstream’ firms that transport and store crude oil, and the breadth of opportunities become clear.
The credit profiles of North American midstream companies benefit from the lack of direct exposure to oil-price volatility. Instead, the majority of their earnings are generated by contracts based on long-term volumes, insulating them from movements in prices.
Despite the recent oil-price correction, even with WTI crude oil prices as low as $40 per barrel in December, North American hydrocarbon production is forecast to continue to increase. This is good news for midstream players, as it means oil pipeline volume growth will continue.
The credit profiles of many midstream companies also benefit from recent efforts to simplify their corporate structures, with holding companies fully acquiring operating entities. Calgary-based Enbridge and Dallas-headquartered Energy Transfer made such moves last year, simplifying their businesses and improving transparency for investors.
Efforts to strengthen balance sheets have also helped improve credit profiles in the sector, with announcements of lower leverage targets by Houston-based Kinder Morgan and Enbridge. Both received ratings upgrades for their efforts.
We also appreciate the efforts made by midstream companies to educate investors on their ESG initiatives. For example, Enbridge held a sustainability session at its investor day in December, which provided insights into the company’s leading pipeline-integrity inspection programme, indigenous-relations strategy and how it is incorporating climate change into its business strategy.
Refining our focus: midstream hybrids
Within the underperforming energy sector, midstream companies that issue hybrids1 – instruments with debt and equity features – have attracted investment-grade ratings. We have invested in this area, seeking exposure to high-yield-like returns from instruments of greater quality. The spread differential between midstream unsecured bonds and hybrids, which has increased amid the recent oil sell-off, illustrates the scope of the opportunities available (see figure 2).
Figure 2. Midstream hybrids v E&P bonds
Source: Bloomberg as at January 2019.
Enbridge stands out from the crowd
We are currently invested in hybrids issued by Enbridge, the pipeline company that transports 25% of North America’s crude oil and 22% of its natural gas.
Enbridge’s credit profile benefits from the company’s size and scale. The business has provided guidance for 2019 EBITDA of 13bn Canadian dollars. It also generates a stable cash flow stream aided by long-term, volume-based contracts.
At an investor day in December 2018, Enbridge’s management team noted that after 2020 the company will generate 3.5bn Canadian dollars of annual free cash flow, available for capital expenditure investments. With an annual debt capacity of 1.5-2.5bn Canadian dollars, the company is planning for 5-6bn Canadian dollars of annual capital spending.
Given its ability to generate internal free cash flow, the company noted that the issuance of equity and hybrids will be less likely for now, which increase demand – and therefore prices – for the hybrids it has already issued.
The spread differential between Enbridge’s hybrids and long-dated unsecured bonds is historically about 160bps. However, amid the recent oil-price sell-off, it is about 200 basis points (see figure 3).
Figure 3. Enbridge: rising differentials between hybrid and long-dated bond spreads
Source: Bloomberg as at January 2019.
In our view, Enbridge hybrids are attractive investments given the high rates of return they offer amid the current energy-sector volatility, the lower credit risks that apply to the midstream company and its strong ability to generate cash flow.
1For more information about hybrids, read “Hybrids revisited: opportunities across the Atlantic”.