There are plenty senseless oil and gas forecasts published by leading financial institutions as an attempt to convince people that oil and gas companies will soon be profitable again due to improvement of crude oil prices. Therefore, it is encouraging to witness that it is still possible to find a report which makes sense. 

The industry’s growing debt is indeed a major concern as we begin to realise that the ability of oil and gas companies to meet their debt obligations is rather questionable. 

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In March 2017, Peter Rawson-Harris, Research Analyst, Macquarie, published “Economic and market highlights” whereby he indicates that with cashflows dwindling, operations have been increasingly funded with debt capital. Over time, demand for capital, increasing risk of default, and diminishing bargaining power of producers has led to higher cost of finance. This reflected in the implied interest rates on US high yield (HY) energy bond indices.

The below chart illustrates the spread in basis points between several categories of bond indices and the benchmark US rate. The spread over benchmark for US high yield (HY) energy has widened from under 400 basis points (bps) in January 2014 to almost 2,000 bps today.

Spread to benchmark US yield curve

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Source: MWM Research, Bloomberg, February 2016. (OAS: option adjusted spread)

US bond indices versus crude oil

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Source: MWM Research, Bloomberg, February 2016

As the slump in oil became a protracted sell-off, investors have responded by reducing exposure to high-cost producers that are struggling to operate profitably. This has led to a corresponding sell-off in HY energy (see the below chart). At the moment, contagion and spillover effects appear to be confined to the most leveraged players, being HY Materials, HY Industrials, and sub-investment grade CCC-rated operators.

US HY bond indices by sector

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Source: MWM Research, Bloomberg, February 2016

While there is some evidence that the turmoil in the US HY energy fixed income market is spreading to the investment grade (IG) market, it appears restricted to IG energy. Spreads on corporate IG energy have tracked higher but to a far lesser extent than HY energy. In last 12 months, Corporate IG bonds spreads have rallied in sympathy from 140bps to 220bps- a far cry from the moves lower credit have endured.

US Corporate IG Energy & US HY Energy

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Source: MWM Research, Bloomberg, February 2016. (OAS: option adjusted spread)

Corporate IG & US Corporate IG Energy since 2015

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Source: MWM Research, Bloomberg, February 2016. (OAS: option adjusted spread)

As credit and monetary conditions tighten, bankruptcies will continue to emerge. However, a wholesale escalation in defaults is more a function of oil price expectations in 2019 and beyond, than today’s spot price. The reason for this is the so-called “wall of maturity”, which refers to the profile of maturing underlying debt issues in the HY energy bond universe. The bulk of US HY energy debt is maturing between 2019 and 2023. For the so-called oil supermajors, repayments are far more closely matched to cashflows, producing a smoother profile.

US energy HY debt maturity profile

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Source: MWM Research, Oxford Economics, February 2016

Oil supermajors aggregated debt maturity profile

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Source: MWM Research, FactSet, February 2016. Based on ExxonMobil, BP, Royal Dutch Shell, Total and Chevron.

Years of zero interest rate policy in the United States pushed borrowing rates to all-time lows. This prompted the oft-referenced “reach for yield” as lenders sought increasingly creative ways to augment returns when less risky forms of investment failed to pay off. HY energy producers readily took advantage of the situation, financing growth with cheap debt rather than equity, pushing the maturity date of the loans as far into the future as possible. At the same time, producers have also sold forward production from wells using derivatives, guaranteeing a price they will receive on their oil for up to two years. Unfortunately, hedging books are rarely opened for scrutiny by all and sundry, so knowing when hedges are rolling off or resetting is difficult to determine. As hedges roll off, producers will find themselves increasingly exposed to a languishing spot price.

Breakeven oil prices vary drastically. Depending on the location, they can be anywhere between $US40 and $US80 per barrel. Many will be cutting deeply into remaining cash reserves, and those struggling to service interest costs will find their future in the hands of banks and investors.

An important consideration will be the outcome of discussions between lenders and energy companies, which take place in April and October each year. This is an opportunity to recalculate the value of properties that energy companies staked as collateral for their loans.  A key input to these discussions is the oil price over the prior 12 months.  A year ago the twelve month trailing oil price was around US$70 a barrel. This year, lenders will likely calculate collateral values off oil priced at US$35 a barrel – half of what it was 12 months ago. As valuations and cashflows decline, banks will cut the amounts they are willing to lend to the sector.  This will make rolling over loans very problematic, it often results in either no financing leading to bankruptcy, or penalty rates of financing, further weakening free cashflow.

This April should result in a number of the marginal shale oil producers going to the wall – marking the first significant cuts to global production since prices have collapsed.  This should also see the price of oil rise as it responds to the re-balancing and more importantly the change in attitude to speculative outflows becoming inflows again.

While broader credit markets are not immune to a further deterioration in fundamentals, it appears that for now the bulk of bankruptcies are likely to be limited to HY energy, albeit with spreads of related sectors like materials and industrials negatively affected. Perhaps the greatest downside risk is that expectations of global growth, specifically China, dramatically miss the mark, leading to a further widening in spreads, a sell-off in equity markets and increased volatility. Visit Macquarie to read more.

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