High-yield E&P energy bonds are risky temptations

November 2
12:05 AM 2014

Investors betting that oil prices will recover are starting to support the battered prices of high-yield bonds from exploration and production (E&P) energy companies.

But market strategists warn they could face steep losses ahead if the price of oil remains under pressure - particularly if they are not more selective about which credits to buy.

West Texas Intermediate, a benchmark for crude pricing, has fallen more than US$20 a barrel since June, from over US$105 at the time to US$82.65 this week.

That tumble has hit bonds in the E&P sector, which have taken a beating in the secondary market.

According to the Bank of America Merrill Lynch Master Index, energy sector spreads widened from around 360bp in June to 576bp on October 15.

But those spreads then tightened 80bp to 496bp by October 24, as the low cash prices drew in opportunistic bargain-hunting investors.

"Clearly there is some optimism that the sector offers value versus the broader market," said UBS strategist Matthew Mish, who believes investors need more due diligence on single B rated E&P names.


At BNP Paribas, credit strategist Mark Howard said the whipsaw price movements were the result of a "tug of war" between differing views on where oil prices are headed.

"High-yield investors think oil prices will stabilize and see E&P bonds as cheap relative to the rest of the market," Howard told IFR.

"Distressed and event-driven funds are rolling up their sleeves and betting oil will fall into the mid/low 70s."

Without question, oil prices will determine the fate of many E&P companies, which typically have bank lines dependent on production volumes and oil prices being at certain levels.

Those that do not achieve enough production at a time when prices are lower - or have not yet started production at all - may lose access to debt capital markets to fund further production growth or survive until prices rise.

"There is concern about less fully formed companies that are going to be exposed if oil goes down to 70," said Howard.

Distressed funds have been shorting energy bonds, expecting the shale boom to be undermined by the global oil glut, and that early production phase companies will run out of cash before full production and free cash flow is achieved.

Oilfield services companies are said to be a particular concern.

Offshore contract drilling services company Hercules Offshore, rated B3/B, saw its 6.75% 2022 bonds drop to 58.75 Friday, sliding further from the mid-60s area after the company disclosed lackluster quarterly results earlier in the month.

Its bonds had already taken a nosedive on the back of falling oil prices, and were trading in the mid-80s at the start of September.

"We are not going to see a lot of bankruptcies if oil stays at 80-85," said Stephen Kotsen, a high-yield portfolio manager at Nomura Asset Management.

"But if it goes to 70 and stays at that level for two to three years, then we could see defaults," he said.

About 40% of the energy sector is rated B2 or lower and has below-average recovery prospects, according to Moody's.

While average one-year default rates for single Bs and triple Cs are 3% and 16% respectively, historically those numbers jump to 8% and 34% in high-default periods.

Even so, the much lower rate of default of single Bs seems to be enough to encourage some investors to take a real punt on the prospect of oil prices not staying lower for too long.

"We are not worried, as we look at bond prices relative to what the assets are worth," said Gibson Cooper, energy analyst at Western Asset Management Company.

He said high-yield E&P had historically lower default rates because of the inherent hard assets behind the bonds, which gave companies several levers to pull during down-cycles.

"The lender generally recognizes the sector as being cyclical, and will work with the companies to maneuver highly leveraged balance sheets and give companies time to perform," Cooper said.

The high-yield energy sector's default rate stood at 0.4% year-to-date through August 2014 versus 2.9% over all of last year, according to Fitch Ratings.

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