In Energy Revolution, Bond Investors Must Keep Their Heads By Ivan Rudolph-Shabinsky and Petter Stensland, Alliance Bernstein
A surge in capital expenditures and leverage in the energy industry could end badly for some companies and their creditors. While select opportunities exist, we think bond investors should think carefully before they blindly bankroll today’s North American energy revolution.
Energy-sector high-yield bonds have been at the epicenter of recent volatility in the global high-yield market. Between late August and mid-November, the US high-yield energy sector is down 6.2%, compared to a 1.7% decline for the broader US high-yield corporate-bond market.
So does this volatility represent a buying opportunity? Or is it an indicator of problems to come?
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In our view, it might be trouble—at least for many small, highly-leveraged companies involved in oil exploration and production—and that’s reason for investors to tread carefully.
Since 2000, energy companies have invested some $1.5 trillion into operations—mostly exploration and production—and they’ve taken on a hefty share of debt to do it. Debt issued by energy firms today comprises more than 15% of the Barclays US High Yield Index, compared to less than 5% a decade ago (Display).
It’s hard to find a historical example of so much money chasing an opportunity that ended well. Typically, such ambitious investment leads to bubbles, and the bubbles eventually burst. Consider the US telecom industry, which saw its share of debt as a percentage of the overall market increase by a similar margin in the years leading up to the early 2000s, when the sector ran into trouble.
Energy Boom Does Not Guarantee Profits
There’s no doubt technological advances and shale-gas discovery in the US and Canada have reshaped North American oil and gas markets. US natural gas production hit a record high in 2013 and oil production has reversed a prolonged decline. This progress is thanks largely to horizontal drilling and hydraulic fracturing—or fracking.
But not every segment of the energy industry stands to benefit. Oil prices are now below $80 a barrel—in part a result of the supply glut caused by the North American production boom. Small companies that have levered up to fund exploration and production will see their margins squeezed—with bankruptcy a distinct possibility in some cases. As a result, many firms no longer have access to capital markets. But we think investors should think carefully before deciding to snap up their existing debt at a discount.
Companies involved in exploration and production—known as “upstream operations”—are vulnerable simply because they’ve earmarked too much capital for production. While fracking has helped increase capacity, the cost of developing production capabilities isn’t likely to be fully recovered.
The Struggle to Recoup Investment
To understand why, let’s again turn to telecoms at the turn of the century. The investments many companies made to lay high-speed network cables proved a boon for internet users. But investors suffered sizable losses because they miscalculated the true cost of those investments.
Like telecoms in the early 2000s, the money being spent on oil and gas field development in recent years may prove poor investments in the long run—even as the lower cost of energy benefits consumers. And the lower the price of oil goes, the more likely it is that companies will struggle to recover their costs.
Onshore service firms that support the energy sector will suffer from any resulting reduction in fracking activity. Meanwhile, an oversupply of drilling rigs that’s already squeezing offshore service providers could get worse.
Opportunities Exist, But Selectivity Is Key
None of this means the energy sector is devoid of opportunities. But the most promising ones, in our view, are likely to be focused on other segments of the industry. Companies that maintain pipelines and oil-storage providers, for instance, typically have less exposure to oil prices because they enjoy long-term contracts. For them, a decline in prices would be a good thing, boosting demand for oil and likely increasing the amount of oil moving through the system.
Likewise, downstream firms—particularly North American refiners—are living in a golden age. Cheaper oil prices reduce their cost of business, allowing them to maintain or even increase margins even as cheaper energy prices boost demand.
Even in the upstream segment, some firms that control attractive oil and gas fields will emerge as winners. But finding these gems won’t be easy, particularly if overall industry turmoil increases. In our view, significant losses for creditors of the least profitable exploration and production companies are a real risk.
When it comes to the high-yield energy sector, investors should proceed with caution.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Ivan Rudolph-Shabinsky is a Portfolio Manager of Credit and Petter Stensland is a Research Analyst, Credit, both at AllianceBernstein, L.P. (NYSE:AB).