There is an old adage in credit markets that last cycle’s problem sector is unlikely to be the source of trouble in the next cycle. The basic theory is that after undergoing a period of stress, the weaker companies in a sector are either downgraded to high yield or survive by focusing on the health of the balance-sheet. No one expects that the next recession will be a financial crisis like 2008/09 because banks are now better capitalized and less systemically exposed—it’ll invariably be a different sector of the economy. And yet, it would seem that the energy sector may prove to be the exception to the rule.
While Covid-19 remains front-and-center for risk markets, the decision by Saudi Arabia to increase oil output after a breakdown in relations with Russia is a significant negative development for credit markets that will contribute to an increase in downgrades and defaults within the energy sector. While we believe it unlikely that WTI remains below $40 long-term, oil prices could remain depressed for much of 2020. As such, the U.S. shale industry is in a very precarious position. Equity valuations have been decimated in recent trading sessions. The industry’s cost of capital is soaring. And the focus is now on liquidity preservation. In the last five days, investment-grade energy spreads have widened to almost the same levels as seen during the energy crisis in 2015/2016. At the long-end of the curve, independent exploration & production companies1 are 300 basis points wider this month alone while midstream companies are 180 basis points wider.
As during the last energy crisis, the rating agencies are likely to play a role in how energy bonds trade over the next year. Coming into 2020, the rating agencies generally expected WTI to trade between $50-55/barrel. Clearly, these assumptions will now need to be refreshed. However, the agencies say that they incorporate periods of stress into their ratings and that these “stress tests” would be consistent with WTI trading at $30-35/barrel. In conversations with Moody’s this week, the agency seems to be satisfied with their current ratings and feeling vindicated after aggressively downgrading energy companies in 2016. Unfortunately, we have less confidence that S&P will not act. As an institution, S&P provides less transparency into their methodology as it relates to prices, and as such, we believe them more likely to downgrade energy companies by 1 or 2 notches in the coming weeks or months.
Coming into March, LGIMA credit portfolios were positioned overweight the midstream subsector and slightly underweight the remaining energy subsectors. Despite having less direct commodity exposure, midstream companies are at risk due to their gathering and processing businesses and the potential for counterparty defaults. However, we believe the sector is more insulated than in 2015/2016 as many midstream companies have focused on deleveraging the balance sheet in the past two years as new pipeline projects have come on-line. While some of our larger portfolio companies (e.g., Williams Companies and Energy Transfer Partners), will now find it more difficult to achieve their deleveraging goals, they have likely made enough progress to stave off near-term downgrades. Within the independent exploration & production sector, liquidity levels, extraction costs and hedging activity will no doubt prove to be key differentiators. Large companies such as Apache and Continental Resources that are unhedged will likely see downgrades to high yield. LGIMA portfolios have no exposure to these companies.
When economic growth slows abruptly, companies that recently completed debt-funded acquisitions are especially at risk as their balance sheet leverage is unusually elevated. In this respect, Occidental Petroleum’s ill-timed purchase of Anadarko leaves them at high risk of a downgrade to high yield. Likewise, Disney’s purchase of certain portions of Fox makes them more vulnerable to a downgrade to triple-B.
After stress testing for a multi-quarter recession, we believe that three companies held in LGIMA portfolios could be downgraded to high yield under that scenario: Occidental Petroleum, Ford, and Petroleos Mexicanos (Pemex). As the weeks and months progress, LGIMA will be in contact with clients to discuss any potential downgrades.
In the near term, we do not expect that energy fundamental risk will improve much. That being said, it is possible that Russia and Saudi Arabia revisit their recent decisions. However unlikely, it is also possible that the U.S. could seek to aid U.S. energy companies through tariff measures or by providing direct support. Short of developments such as these, we expect the volatility within the energy sector to remain elevated.
Away from energy, the performance of the investment grade credit market is not likely to improve until investors are confident that monetary and fiscal policy action will be sufficient to prevent lasting damage to the global economy. Actions by the European Central Bank (ECB) and Federal Reserve on Thursday helped to improve sentiment on Friday, but more measures are likely needed. In the coming week, we would expect that the ECB will need to be more explicit with respect to their support of peripheral sovereign debt and their intended pace of near-term asset purchases. Meanwhile, the Fed’s actions this week to restore liquidity to the Treasury market were much needed, but Chair Powell likely will need to cut rates to zero at the March 18th meeting or beforehand and articulate how the Fed will respond going forward if financial conditions continue to tighten.
Given the potential economic severity of Covid-19, investors are also looking for a meaningful fiscal response from governments around the world. Friday’s announcement that Germany will look to spend whatever is necessary to offset the economic impact of the virus is a good start. Relaxing the Eurozone rules around deficits so that other countries like Italy and Spain can do more is also needed. In the U.S., the bipartisan legislation to provide paid leave for those affected by the virus is encouraging, but investors will expect further measures targeted at specific industries and will need evidence that partisanship will not impede relief efforts.
1 An exploration & production (E&P) company is in a specific sector within the oil and gas industry. Companies involved in this area of exploration and production focus on finding, augmenting, producing, and merchandising different types of oil and gas.
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