Look out your window and you will see a sea change occurring in the public equities marketplace in the oil and gas sector: High-yield fixed income is hot; public equities are not.

2017 transpired as a transformative year for energy capital markets, perhaps unexpectedly. Equity raises ruled the landscape the previous two years—some $30 billion plus each year—as producers rushed to tap the markets to bolster balance sheets in a weak price environment, and investors looked to capture the anticipated updraft in commodities following painful lows.

Alternately, high-yield debt investors largely sat on the sidelines as E&P and service company bankruptcies slogged their way through the system, waiting for a new day.

This year was supposed to be the year the industry recovered, brushed the downturn dust off its steel-toed boots and went back to work. Then West Texas Intermediate (WTI) softened in the second quarter and swooned to close to $40 per barrel (bbl) over the summer, before rising to $60 and then settling around $50. After a robust first quarter, equity investors pocketed their billfolds amidst price uncertainty, and the market seized up. Just $6 billion in energy equities have been raised year-to-date, less than most individual quarters last year, and the first quarter accounted for $4 billion of that.

Debt issuances, though, gained traction in recent weeks as high-yield investors saw stability in commodities.

The tide is turning for each investor class.

The equity view

First, the bad news: Equity investors are staying away from the energy sector because they see little hope for commodity upside. E&P and oilfield service stocks have “dramatically underperformed” the broader markets for several years now, observed Jeff Tillery, managing director and head of capital solutions for Houston-based investment bank Tudor, Pickering, Holt & Co (TPH).

Year-to-date, the energy sector is down 8%, while the overall S&P 500 is up 14%. Compare that with the technology sector, which is up 28% year-to-date, and the push-pull of money as viewed by a generalist institutional investor becomes apparent.

“There’s the view that, ‘Yes, maybe energy has underperformed, and maybe it’s relatively cheap, but every dollar that I’ve diverted toward energy vs. sectors that have led the market have driven underperformance,” Tillery explained.

With the forward strip flat at plus or minus $50 for “a long, long time,” and without the anticipation of a commodity tailwind, investors question why they need to own more now, he said.

Morgan Stanley managing director Dennis Cornell concurred that the first nine months of this year have been “very difficult” in the energy equity space, with energy being “one of if not the worst” performing sectors in the S&P 500. “Investors are skittish; they aren’t backing up the truck for this space,” he said.

Sentiment around both oil and gas prices is driving the malaise, he said. “There’s always the concern that North American producers will always over-produce.” On natural gas, the view is that the U.S. has a lot of it, and long-term gas pricing is “relatively unattractive.” On crude, the anticipation was for a “slow up and to the right” trend pushing $60/bbl by year-end.

“Investors lost faith that we were going to be $60 or $70. Now they’re worried about 2018 and are getting skeptical that this is going to last.”

Absent alpha

Joel Foote, senior managing director of the energy group for Guggenheim Securities LLC, emphasized that “equity investors are extremely focused on the alpha generator for new issuances,” he said. Without a catalyst for relative outperformance vs. the broader equity opportunities available to investors today, “absent a truly misunderstood equity story or an expectation of a meaningfully improved outlook on commodity prices, energy equities are currently struggling to catch a bid in the marketplace today.”

Historically, equity investors are emboldened by a view of rising commodity prices, but the view now is for a very narrow band of volatility, with little expectation for $75 or $100 oil on the horizon. “Given the conservative outlook on forward commodity prices, appetite for equities has been meager,” said Foote.

Equity investors, too, might be gun shy following the downdraft in equity valuations in 2017. The whoosh of capital out of the equity markets has depressed corporate valuations, dragging down returns on the billions in investments that poured into the sector over the past two years.

Vidisha Prasad, Guggenheim managing director, energy investment banking, observed that “the sector has continued to be under pressure, leading to a conservative outlook on the buyside.”

“In many cases there’s a divergence between corporate results and stock prices,” Morgan Stanley’s Cornell said. “Valuations are not reflecting what owners believe is the intrinsic valuation of their companies, which makes it very difficult—even if there was a market—for owners to sell equity.”

Thus, few have tried since the second quarter. Carrizo Oil & Gas Inc. priced $228 million of common stock in June to partially fund an acquisition. Ring Energy Inc. raised $60 million for Permian capex in July. In October, Matador Resources Co. succeeded in a $210-million offering to fund a Delaware Basin purchase. At press time, Midland Basin and Eagle Ford Shale player Earthstone Energy Inc. squeezed out a $45-million equity offering at a 9% dilution to pay down its revolver. And that’s about it. Midstream equities have fared somewhat better, if only incrementally.

Despite the dearth, Foote discredits the notion that the equity market is closed to E&Ps. Rather, equity investors are just selective.

“If equity investors see a value opportunity that creates alpha for that particular investment, they will support it.”

West Texas acquisitions funded by equity raises dried up because acreage valuations on the rise caught up with share valuations on the decline, removing the value arbitrage that once existed. In fact, a number of marketed transactions did not come to fruition, he said, because that arbitrage is no longer there.

But that doesn’t mean equity investors aren’t game. “They have not been presented an opportunity to finance an acquirer that is currently trading in the marketplace at a meaningful premium to the acreage that is available,” he ascertained, regardless of the basin.

Morgan Stanley managing director Geoff Davis clarified that the equity market, while challenged, is not closed. “It doesn’t mean it can’t happen for the best assets. The question is, do I want to further dilute myself at these share prices?”

Debt on fire

Conversely, as equity tides reveal barren beach, public E&P debt issuances are rolling ashore.

Foote characterized the current fixed income market as “quite open,” with a “tremendous amount of activity” coming to market since Labor Day. The deals, he said, are being driven by attractive terms for which energy companies can lock in duration capital.

High-yield investors now view the worst of the commodity price collapse and correction as being in the past, and the chances of re-visiting Draconian levels on the downside as nil in the foreseeable future. Also, sentiment around the commodity curve is that both gas and oil will hold to a very tight band around $50 WTI and $3 thousand cubic feet. Together, this stability leads to comfort in the credit markets.

TPH’s Tillery also views the market as “extremely healthy. It may not be open for every company and every basin, but for companies that have what the market perceives to be low-cost assets, that window is definitely open.”

Confidence around oil price is one element, Tillery agreed. A second element, though, is investor confidence that companies are balancing both what is a great resource and growth opportunities with financial discipline and a focus on all-in return on capital.

Cornell described high yield currently as “very, very strong.” In lieu of public equities, “high yield is another way you can pay down a revolver and reload with longer-term capital. It’s more accessible right now than the IPO market. There’s a lot [of offerings] out there, and there’s a lot more coming.”

Selling too cheap into the equities market doesn’t make sense, he added, so high yield becomes an alternate form of capital.

Since the start of the second quarter and through early October, 15 U.S. E&P companies have tapped the fixed-income market for some $14.5 billion, precipitated by a drop of the 10-year Treasury note to 2%, its lowest point since last year. Many of these took advantage of the opportunity to refinance higher-yield loans, others to extend maturities.

Cornell mentioned an additional five deals represented by Morgan Stanley yet to price at press time.

“We are seeing a refinancing trend motivated by the market pricing opportunities,” Tillery said. “Companies are refinancing for significantly lower coupons than what was on their existing debt outstanding.” Guggenheim’s Prasad added, “If you can do that, issuers have an incentive to strengthen their capital stack.”

Concho Resources Inc. priced an offering of $1.8 billion in September in two transactions bearing interest of 3.75% and 4.875%, replacing two loans with interest of 5.5% each and shorter maturities. Privately held, Midland, Texas-based CrownRock LP offered $1 billion in principal at 5.625%, replacing notes with coupons exceeding 7%. Chesapeake Energy Corp. added $750 million in unsecured, 8% notes to finance tender offers for outstanding notes with nearer-term maturities. Denver-based Jonah Energy LLC closed an upsized offering of $600 million of 7.25% senior unsecured notes due 2025 to pay down its revolver.

“Those were all instances of refinancing as opposed to companies that are stepping on the accelerator and trying to finance and outspend,” Tillery noted. Further to that point, he said the market is looking for operators to show “a bit more discipline” before backing the issues.

In addition to balance sheets, asset location matters as well. Many of the issuers that have come to market are those with interests in the Permian Basin, a favored basin not only amongst asset acquirers, but also debt investors.

“The Permian companies are raising high-yield bonds at 4.5% to 6%; it’s a favorable market for Permian issuers,” Prasad said, noting that long-term Permian yields in some cases are lower today than they are for certain large-cap diversified players.

Parsley Energy Co., WPX Energy Inc. and CrownRock are further examples of Permian players reaching for high yield at attractive terms.

Outside of the Permian, E&Ps are finding coupons with 7% to 8% yields typically. Marcellus and Utica shale-focused Southwestern Energy Corp. recently priced $1.15 billion in senior notes at 7.5% and 7.75%. Extraction Oil & Gas Inc. in July accessed the high-yield market for $400 of $7.375% notes for Niobrara drilling. The aforementioned Jonah Energy at 7.25% operates in the Piceance Basin, and Chesapeake Energy, with an 8% yield, in various basins including the Eagle Ford, Haynesville and Marcellus shales.

Depending on basin and balance sheet, the market is available for refinancings, but Permian deals get significantly better terms generally. Exceptions: Gulfport Energy Corp., with assets in the Utica Shale and Oklahoma’s Scoop/Stack plays, priced $450 million in July at 6.375%. EQT Corp., to fund a portion of its acquisition of Rice Energy Inc. with Utica and Marcellus shale holdings, priced $2.5 billion in three deals ranging from 2.5% to 3.9% yield.

The key to getting investor support for debt financing, said Tillery, is having low-cost assets where the market is known and has running room. The Marcellus and Scoop/Stack warrant investor confidence in addition to the Permian, he said.

But while the high-yield debt market is seemingly on fire for a certain group of energy companies, Prasad said she still does not see debt money available for companies with outstretched balance sheets.

“I don’t believe we have reached a level of irrational exuberance,” she said. “We’re in a healthy enough market where the right assets with the right economics and the right balance sheet can refinance, but it’s not back to a bull market scenario yet.”

Tillery agrees. “The ‘have-nots’ are companies that still have, in the market’s view, too much financial leverage or not enough inventory depth.”

Since the Treasury’s dip in September, it has climbed a bit to 2.3% basis. That alone won’t be enough to close the window for debt, assured Foote.

“I don’t think that has a meaningful impact on the availability of capital for the right management teams, the right rock and the right balance sheets,” he said. “Two point three percent from almost any historical context is a low benchmark. The tightening of spreads on top of that has made it a very compelling market for energy companies to tap at incredibly tight levels.

“Based on everything we can see right now, it feels like a pretty good window. It feels like we’re in relatively smooth waters relative to what we’ve all navigated over the last several years.”

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