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Deep Dive: Drilling down into oil & gas sectors — a look at volatility, risk

Capital Markets View – February 2021


LCD Monthly: Demand for US loans puts borrowers in the driver's seat

Capital Markets View – January 2021

2021 Leveraged Loan Survey: Defaults edge higher; credit quality a concern

Deep Dive: Drilling down into oil & gas sectors — a look at volatility, risk

Saying "oil demand remains weak," the International Energy Agency, in its most-recent report Dec. 15, cut its forecast for global energy consumption in 2020 to 91.2 million barrels per day, some 0.1 million barrels per day less than it projected one month earlier, and a drop of 8.8 million barrels per day from last year. Although the IEA sees a 5.7 million barrel per day rebound in 2021, it believes "it will be several months before we reach a critical mass of vaccinated, economically active people and thus see an impact on oil demand."

Reflecting the pain such a demand contraction could entail, law firm Haynes and Boone reported that 45 exploration and production companies and 57 oil field services companies have filed for Chapter 11 through November 2020, already more than the 42 and 21 filings, respectively, for all of last year. The law firm's data shows the pace of bankruptcies now slowing, while an opposing stream of companies are emerging from restructurings with lower leverage and stronger balance sheets.

Headlines such as bankruptcy filings help keep the already high-profile oil & gas sector in the glare of Wall Street's spotlights. The often-significant fluctuations in crude prices add another attention-grabbing element to the sector, with numerous investment managers saying recently they are steering clear of the segment (oil & gas comprises a relatively slim 3% of the $1.2 trillion U.S. leveraged loan universe and a more sizable 13% of the S&P High Yield Index). Indeed, according to LCD, oil & gas leveraged loan issuers for much of 2020 have seen more distress than any other industry, though they have recently been overtaken by the leisure sector, which has been slammed by COVID-19 lockdowns throughout much of the year.

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Broad brushstrokes
But despite the one-size-fits-all view taken by some in the markets, there is not one singular reason that can be applied across various oil & gas subsectors to fully capture volatility and risk within the sector. Of course, oil prices are key. One needs to look no further than the brief period this April, when oil futures plummeted below zero, to a low of negative $37 per barrel. The world had flipped upside down: sellers needed to pay buyers to take oil off their hands.

Avoidance of oil and gas may also be attributed to damage done to portfolios, balance sheets and stomach linings during the longer-playing 2014-2016 commodity price decline, and then again in 2020's second and third quarters. Or maybe it is the result of what might be the sector's potential issues with ESG guidelines, which continue to gain traction with corporates globally.

Regardless of the reasons, Haynes and Boone's data hints that the sector is more nuanced than the broad brushstrokes often applied to it. In fact, the linkage between each of the sector's three distinct subsectors — upstream, midstream and downstream — and their underlying commodities is perhaps to a surprising degree not uniform. The variety of linkages means risks may vary, as well.

More Deep Dives: Recessions show how purchase price multiples link private equity, distressed debt

This last dynamic is not lost on those seeking opportunities in the market, of course. As one long-time distressed investor put it, "If everyone is avoiding something, maybe it's time to take a closer look."

Revenues of upstream companies — the E&P entities that explore and produce oil and/or gas on land or offshore fields they own or lease — are most directly impacted by commodity prices, as those prices are paid on the open market for their production. Services, a subsector within upstream, is equally tied to commodity prices, as services company revenues are dependent on their E&P company customers.

On the other hand, midstream company revenues are often not directly impacted by commodity prices. These companies frequently work under long-term contracts, in which a producer must push one of the commodities into, say, a pipe or onto a truck or train at one end, with a refiner waiting for it at the other. The price of oil or gas does not usually directly matter.

Commodity prices can, however, indirectly impact midstream companies. For instance, if low prices drive producers to pump less oil, and so generate less revenue, some of them may not be able to live up to minimum-volume clauses of their midstream transportation company contracts, nor have the liquidity to pay the minimum amount owed on those contracts.

Under bankruptcy law, bankrupt producers may be able to reject their midstream contracts, market professionals say, though that is not definite. "It's complicated," observes Brock Hudson, managing director at Carl Marks Advisors, about the issues around midstream contract rejection (to be sure, the rejection would give rise to a claim on the bankrupt entity by the midstream company).

Downstream companies are also not generally, over an intermediate term, directly impacted by the price of oil or gas. For them, the spread is the key, as they make money on the difference between what they pay for the commodity and the price for which they sell their refined products. In the short term, however, commodity price moves may alter the spread, if at all, in unpredictable ways.

Fine tuning
Not only are companies in the three oil & gas subsectors impacted differently by prices, but that impact can be — and lately has been — fine-tuned.

A widely used industry valuation methodology for upstream companies is the PV10 calculation of in-ground reserves. The computation values the cash flow — revenue less direct lifting expenses — derived from proved, developed and producing assets and sometimes from proved but undeveloped reserves, generally over 30 years, discounted at 10%.

Recently, this calculation has taken a conservative pivot, as the discount rate used by analysts and players in the acquisition & divestiture market has often been increased to 15% or 20% (and even higher), the new result appropriately called PV15 and PV20. According to Alan Gelder, vice president at oil & gas research and consultancy firm Wood Mackenzie, raising the discount rate "would be a reflection on the part of the buyer as to the sustainability of future cash flows."

Because higher discount rates reduce the significance of cash flows in later years, they lower asset values.

Midstream companies generally slot into the opposite end of the oil & gas risk curve from E&P companies. In theory, they have a steady and locked-in revenue stream, and relatively few end up in bankruptcy. Haynes and Boone reported only five midstream company bankruptcies through November 2020, against 102 by upstream companies. Yet their debt generally trades wider than the debt of its peers. It is considered a double-B rated sector, but midstream BBs tend to trade at higher yields than the high yield BB index average, signifying the market's perception of this subsector's relative lack of safety.

According to Wood Mackenzie principal analyst John Coleman, however, midstream company risks are not all equal. On the plus side, he says, "most entities that enter into firm long-haul transport agreements also tend to be the larger, better capitalized, high credit rated entities," with cash flows somewhat insulated from oil & gas pricing and restructuring risk.

But on the minus side, Coleman points, as an example, to commonly used dedicated acreage contracts, which commit a producer to transporting through one midstream company all the oil or gas lifted from a specific field or a defined geographic area. Dedicated acreage contracts can leave a midstream company vulnerable when production in that field becomes uneconomic.

Coleman also raises concerns about "the significant excess capacity that is in place in many regions in the U.S." He says that "waves of contracts" are coming up for renewal between 2021 and 2023, and he expects contract rates will be negotiated "much lower" than the contracts they will replace. That would mean less cash flow for midstream company debt service.

Steve Levitan, managing member and portfolio manager at Scott's Cove Management, notes that midstream companies can protect themselves by diversifying their customer base, and so not relying too heavily on a single producer, or a single oil & gas producing region. He adds that investors can protect themselves precisely the same way, by diversifying across multiple midstream companies or geographies, and selecting those with broader, rather than narrower, customer bases.

The dominant companies inhabiting the downstream subsector are generally large, highly rated multinationals. Still, the high-yield and leveraged loan space contains some of these companies. While, as mentioned, for downstream entities the spread is more important than underlying commodity prices, one sell-side oil & gas analyst pointed out that, in the short-run, the lag between a commodity price move and the spread's adjustment to that move can be a source of significant risk, with commensurate impact — positive as well as negative — on downstream company earnings.

Refiners can reduce operating risk by, among other things, hedging the spread in the futures market, locking in prices and so modulating commodity-price-driven cash flow changes. E&P companies can use futures to hedge as well, altering their innate exposure to their commodity.

The same hedging tools used by oil & gas companies are also available to the sector's leveraged debt investors, but investors have additional hedging options. They can, for instance, buy, or sell short, exchange-traded funds, or ETFs, structured to mimic the price moves of the underlying commodity. One step removed from ETFs is equity options on the underlying ETF, along with common stock options on specific companies in the sector. Finally, leveraged debt positions can be hedged with credit default swaps.

Not only the companies, but the securities of oil & gas companies themselves, in all three subsectors vary in their levels of risk. Aside from secured bank debt, secured and unsecured bonds, and equity, one buy-side portfolio manager mentioned a hybrid perpetual preferred security issued by some of the larger and better-rated midstream companies. Like bonds, they are $1,000-face securities with mid-single-digit coupons trading in the 60s to 80s. Though Libor-based coupon resets in two years or so will lower their near-10% current returns, their position below the debt stack and above equity gives them unique risk/reward characteristics.