[Editor's note: A version of this story appears in the August 2018 edition of Oil and Gas Investor. Subscribe to the magazine here.]

A rising interest rate environment does not normally bode well for bonds, but the high-yield energy sector has had some tailwinds. Although West Texas Intermediate (WTI) prices have retreated from the low $70s to the mid-$60s as of mid-June, they are still up from the low $50s in early 2017. Higher prices, of course, tend to translate into higher E&P cash flows, improved liquidity and better balance sheets.

But there has also been a change in E&P managements’ approach to tapping the high-yield market, as well as the market’s view of a more conservative E&P strategy. As E&Ps have set targets for generating free cash flow (cash flow > capex), capital market activity has focused more on extending out upcoming maturities opportunistically and keeping leverage low in case of commodity weakness.

Tarek Hamid, a senior analyst covering the energy high-yield sector at J.P. Morgan, recalled former times—before E&Ps generally adhered to capital disciple and financial conservatism—when the “way to do business was to max out your borrowing base and take down everything against it to drill. And then, when it got full, you would issue bonds to pay it down. Then, you would repeat.”

That was then; how times have changed!

The Self-Funding Strategy

“The new way of business now is that you try to structure a drilling program so that within 12 to 24 months you can be self-funding,” said Hamid. “You try to keep your borrowing base in reserve in case the commodity does not cooperate with your plans. It’s a much more mature industry structure and reflects a more reasonable, conservative financial strategy.”

Paul Chambers, a senior high-yield energy analyst for Barclays, has seen a similar change in investor attitude.

“There’s been an evolution in how investors approach the sector,” he said. ”Historically, capital was available for those who were seeking growth, not necessarily returns. Now, capital is available, but first, management must provide a tangible business plan that clearly defines when a company is expecting to reach free-cash-flow neutrality or be free-cash-flow positive.

“From a credit standpoint, there certainly needs to be a defined path to reducing net leverage over time,” Chambers continued. “I would say most high-yield companies need to let us know that they’ll be in a free-cash-flow neutral or free-cash-flow positive situation within a window of 12 to 18 months, regardless of the commodity price.”

Through early June, issuance of high-yield energy bonds had increased moderately over last year’s level, as might be expected with an improvement in oil prices. Exact data vary by source, but issuance is estimated at around $25 billion through early June vs. $40 billion in all of 2017. Despite a higher run rate in early 2018, analysts expect full-year 2018 issuance to come in a shade below last year’s level.

Interestingly, through mid-June, the total return of the high-yield energy sector, up 1.1%, had outperformed the overall high-yield bond index, up 0.4%, according to Barclays. This compares to most other asset classes in fixed income, which have had negative total returns year-to-date. The 10-year U.S. Treasury, for example, has lost money as yields have moved from roughly 2.4% to 2.95% this year.

Stronger Universe Of Names

The current high-yield energy index composition is now “largely cleansed,” according to Hamid, following defaults of as much as 24% that occurred in the sector, mainly in the second half of 2015 and the first half of 2016. The new names added to the index were formerly investment-grade names, creating a “much better universe” than the weaker names that exited.

As a result, the underlying volatility of the index has come down, as has its correlation to crude prices, according to Hamid. For the prior six-month period, the high-yield energy index traded in a “relatively tight” range, with yields moving from a low of around 6.5% to a high of 7.1%, he said. The yield over the comparable (about five years) U.S. Treasury ranged from about 400 to 490 basis points (4% to 4.9%).

“It’s traded in a relatively constrained band for the last six months and, really, for the last year,” he said. As of mid-June, the spread over the comparable U.S. Treasury stood at about 435 basis points.

Naturally, the high-yield sector is far from immune to changes in the market outlook of its E&P issuers.

“From a basin standpoint, everyone was ‘all Permian, all the time in 2017,’” recalled Hamid. “Now in the Permian, there’s dysfunction in terms of price differentials between market hubs as we wait for additional takeaway capacity to come to the market in 2019. For now, we have very wide Midland-Cushing differentials, and Permian bonds have traded off modestly.”

In terms of individual issuers, Hamid said names like Callon Petroleum Co. (NYSE: CPE), SM Energy Co. (NYSE: SM) and Halcón Resources Corp. (NYSE: HK) had seen their bonds trade off by 50 to 75 basis points from roughly mid-May to mid-June—a relatively modest amount compared to the very steep sell-offs in some of the Permian equities.

“The bond market does tend to take a slightly longer-term view of these things than the equity market,” observed Hamid. “The answer to a temporary problem with basis in the Permian is to slow down activity. If I slow down and stop burning as much cash, my credit metrics actually look a little better in the near term. A slowdown in activity would cause credit metrics to look better and not worse.”

More Diversification

The Permian issue has led to “a little more diversification by basin in 2018,” said Hamid. “The Bakken and the Eagle Ford [shales] look relatively more attractive right now,” he said, with bonds issued by Whiting Petroleum Corp. (NYSE: WLL) and Oasis Petroleum Inc. (NYSE: OAS) trading to yield about 6% vs. 7% historically. In the Eagle Ford, with its premium prices vs. WTI, benefits accrue to bonds of EOG Resources Inc. (NYSE: EOG) down to Sanchez Energy Corp. (NYSE: SN).

In terms of factors driving bond issuance, “capex used to be the primary long-term driver of growth of the high-yield energy market,” said Hamid. “But it’s not going to be capex to the same extent going forward. It’s going to be much more acquisition-driven, whether it’s traditional A&D activity, which has been active, or corporate M&A, which is often talked about but rarely seems to actually happen.”

As an example, Hamid pointed to well-publicized plans by BHP Billiton Ltd. (NYSE: BHP) to shed its North American onshore assets. “But there is a number of other assets out there as well [as BHP’s]. There’s still a tremendous backlog of assets that companies have announced are for sale, but we don’t know if the buyer will end up being private equity or corporates.”

UPDATE: BHP Billiton Exits US Shale For $10.8 Billion

In the Haynesville Shale, Hamid said, there have been a number of acquisitions by private-equity-backed firms that have initially paid for by cash and funds from a bridge loan. Subsequently, the buyers have gone to the high-yield debt market for financing to pay down the bridge loans. Examples include Covey Park Energy LLC, Vine Oil & Gas LP and Indigo Natural Resources LLC.

Extending Maturity

According to Barclays’ Chambers, “the preponderance of offerings this year has gone to extend the maturity runway as opposed to being for growth capital. During the last 12 months, we’ve seen a number of high-yield companies push the bulk of their maturities into the middle of the next decade. And as we move into a cyclical recovery in energy, that’s provided an added level of comfort for credit investors.”

Chambers pointed to energy becoming populated by more “credit-friendly” managements, who are focused on, among other factors, “minimizing outspends” and targeting returns not just at the field level, but at the overall corporate level. “As more credit-friendly managements have emerged in energy,” he said, “the ability to have maturity obligations eight years out is a very attractive feature for the sector.”

While some observers like to track the “maturity wall” building up by year going forward, Barclays doesn’t view front-dated maturities as being elevated to a level that might cause concern, according to Chambers. Earlier this year, pending 2019 maturities were beginning to stack up, but a number of the bonds have already been refinanced, he said. To add context, maturing bonds in any year typically represent only a small amount relative to the $185 billion high-yield index, he noted.

Barclays groups high-yield issuers into three categories. The highest, rated BB, has recently been trading to yield about 5.5%. This group includes Antero Resources Corp. (NYSE: AR), Diamondback Energy Inc. (NASDAQ: FANG), Newfield Exploration Co. (NYSE: NFX), Oasis Petroleum, Parsley Energy Inc. (NYSE: PE), PDC Energy Inc. (NASDAQ: PDCE), QEP Resources Inc. (NYSE: QEP), Whiting Petroleum and WPX Energy Inc. (NYSE: WPX).

Trading at a yield closer to 7% is the group rated B, which includes Callon Petroleum, Carrizo Oil & Gas Inc. (NASDAQ: CRZO), Extraction Oil & Gas Inc. (NYSE: XOG), Laredo Petroleum Inc. (NYSE: LPI), SRC Energy Inc. (AMEX: SRCI), SM Energy and WildHorse Resource Development Corp. (NYSE: WRD). The third group, rated CCC, trades on a yield basis of around 11% and includes Chesapeake Energy Corp. (NYSE: CHK), California Resources Corp. (NYSE: CRC), Denbury Resources Inc. (NYSE: DNR), EP Energy Corp. (NYSE: EPE), Halcón Resources and Sanchez Energy. It is the latter group that has had the strongest recovery—but only after the farthest fall in the downturn.

“When oil started to recover in 2017, the triple-C bonds initially underperformed due to perhaps an initial skepticism about the sustainability of oil and likely the companies’ need for $55-per-barrel oil to start showing improved net leverage. However, year-to-date, triple-C energy has outperformed both triple-C corporates in general and high-yield energy as a whole by about 250 basis points,” said Chambers.

“We’re seeing in triple-C names a recognition of credit-friendly managements’ adjusted business model to reflect a lower-cost structure and a pathway to free cash-flow neutrality, even for the more distressed names,” he continued. “That’s translating into overall less volatility and more of a belief in the recovery of their underlying financial instruments.”

At the other end of the high-yield spectrum are many of the recently less rock-solid Permian Basin names.

“Over the last several years, Permian credits have been among the tightest in the sector, but we are entering an interim period where bottlenecks and logistical issues are adding a headwind to the Permian names,” said Chambers. “However, these issues should be mostly resolved by the end of 2019.”

‘A Little More Cautious’

James Spicer, Wells Fargo’s senior analyst in high-yield research, said, “The market is certainly open for high-yield energy issuers today,” although rates have risen, and a note of caution has crept into the overall market. “The high-yield market as a whole has grown a little bit more cautious,” he commented.

In part, the added caution reflects concerns regarding interest rates. The Fed raised short-term interest rates by 25 basis points on June 13, with further increases expected over the balance of this year.

“We’ve seen outflows from high yield in general as investors have pulled back from the asset class,” observed Spicer. “Most people see the overall high-yield market as pretty fully valued at this point. There’s not a lot more room for additional spread compression, as spreads are relatively close to historical lows. If rates continue to rise, it puts pressure on the whole market.”

As for energy specifically, the high-yield energy index as of mid-June was trading 410 basis points over its U.S. Treasury counterpart, a wider spread than the 350 basis points prevailing for the overall high-yield index, said Spicer. This is a departure from many years when it traded “inside” the overall high-yield index, as energy was viewed to have more “defensive” characteristics, he added.

“People’s perception of risk in the sector has changed to some extent as we’ve come out of the downturn,” he observed. “There’s a debate going back and forth over whether energy really is a defensive sector, and should trade inside the overall market, or whether because of the nature of commodity price volatility it really is not a defensive sector and should trade wide of the index.”

That said, there’s a “great majority of companies that are trading very tight—almost record tight levels—and that’s balanced out by a few companies trading at pretty wide levels,” according to Spicer. “For example, Permian producers are generally trading very, very tight to the market. They have not been hit nearly as hard on the bond side as they have on the equity side due to the differential concerns.”

Market Open If Expectations “Realistic”

For potential issuers, “we’ve come off the highs of late January/early February, but you can never exactly know when it’s the best time to hit the market and get the best print,” said Spicer. Since then, the market has risen “somewhere between 50 and 70 basis points,” and investors are becoming “more discriminating” and likely to demand more in terms of a larger premium for new issuers.

“But the high-yield market is essentially open as long as companies have realistic expectations around pricing,” affirmed Spicer. Market terms of 5.5% back in February may now be 6% to 6.25%. “I think companies are still adjusting their expectations of where the market is. There’s still appetite from investors at the right price; it’s just that the price has moved up a little bit.”

As examples, Spicer cited bonds issued by Whiting Petroleum and Oasis Petroleum that mature in 2026 as both trading at a yield of 6.125%. Similar bonds by SM Energy were trading at about 6.9%, while PDC Energy bonds were trading at 5.9%. These levels were about 50 basis points higher than in early 2018, he noted, “but they haven’t moved that much.”

Bottom line: “The bond market is open. Companies can get deals done. Investors may look for more of a premium than in the past, but a lot of it may be just market-related, because the whole high-yield market is a market where investors are demanding just a little more return now.”

But issuers are not necessarily stepping up in droves, according to Spicer. “Most companies are not desperate to raise capital right now,” he said. “With higher prices, you’re seeing borrowing bases increase. A lot of companies have more access to capital from the bank market than they did a year ago, and companies are trying to move more toward a spending-within-cash-flow model.”

Bond Issuance Over Equity

For those needing to raise external capital, “the No. 1 source of capital remains the bank market and just to draw down on the revolver,” said Spicer. “After that, there’s certainly a preference to doing bonds rather than equity, because most companies still view their equities as undervalued. But the need for external capital in this market for E&Ps is less than it has been for a while.”

Spicer holds out the possibility of a rotation from other high-yield sectors into energy. The energy sector still trades at a discount to the overall high-yield market, he noted, and it has emerged as a “more healthy” sector coming out of the downturn. “Companies have spent the last two years fixing their balance sheets,” he said, “and have been forced into this new mentality of capital discipline.”

The one subsector that has fallen short in terms of market excitement has been the natural gas sector.

“We see meaningful macro challenges in the natural gas market over the next 12 to 18 months,” said Chambers. “This is in spite of strong growth in LNG exports and continued strong growth expected from the Mexican market importing U.S. natural gas.

“Without plans for meaningful curtailments in the Permian, associated gas production is expected to greatly exceed takeaway capacity until October 2019, when the Gulf Coast Express Pipeline comes online,” he observed. “And other areas where we see adequate transport capacity, like the Haynesville and Appalachia, are showing surprisingly strong gas production growth, leading to an oversupplied market as we head into 2019.”

“The majority of E&Ps in the high-yield sector are hedged for natural gas in 2018, but remain only modestly hedged in 2019,” he added. “With natural gas futures around $2.80 per thousand cubic feet [Mcf] for 2018, it creates a scenario where you could see net leverage increasing for that particular subsector. Credits in natural gas-biased E&Ps in high yield have been some of the worst performing bonds in the sector this year.”

The ‘Saudi Arabia Of Natural Gas’

“Where people want gas names, it’s only ones with the lowest cost, such as in Appalachia and unique assets in the Haynesville,” observed Hamid. “At the end of the day, it’s very hard to make a case as to why gas should be materially above $3/Mcf long term. We are the Saudi Arabia of natural gas. We have an enormous amount of gas, and we’re incredibly good at getting it out of the ground.”

Given the major strides made by the industry since coming out of the downturn, is the anticipated adherence by managements to capital discipline already baked into the bond market—and justified?

“The bond market is cautiously optimistic on capital discipline,” said Hamid. “We’re certainly not pricing it in entirely. We’re giving management teams some credit that, circa 2019, the vast majority of issuers are going to turn the corner to cash-flow neutrality.”

Chris Sheehan can be reached at csheehan@hartenergy.com.

Comments