The recent oil price decline has dramatically impacted the performance of the high yield energy sector and has also significantly impacted the performance of the broader high yield bond market. Energy basics…the high yield energy sector currently comprises 13.50% of the broad high yield market and is composed of four distinct sub sectors: independent energy, 7.50%; midstream, 3.90%; oil field services, 1.60%; and refining, 0.50% ( as measured by the BaML US High Yield Master II Constrained Index*). Independent energy companies explore and produce, midstream issuers pipe and store, servicers drill and support, and refiners convert into products we can use. Independent energy issuers’ oil price exposure can vary widely, depending on but not limited to: asset mix and quality, liquidity, quality of management, and hedging profile (ability to withstand severity and duration of the decline in the price of oil). Midstream issuers have limited direct exposure to the price of oil; some will realize a reduction in earnings growth from assets that provide services to oil plays. Given the relatively short term contractual nature of the industry, services companies are generally the most immediately exposed to commodity prices. Meanwhile refiners are neutral to a net beneficiary in a declining oil price environment.
Energy Sector Now
The average price of the energy sector bond is now $88, down from approximately $105 on June 30! On June 30, trading levels with very few exceptions showed little dispersion regardless of sector or rating. Not anymore. The average BB rated energy bond is currently trading around $98 down, 8pts from June 30. The average CCC rated $70, down $34 pts. Dispersion! Independent energy companies lead the industry and are reassessing capital expenditure budgets for 2015. Many have released preliminary budgets down 30-50% versus 2014. We expect defaults in the independent energy sector during 2015 to be limited driven by a combination of reduction in capital expenditures, lower oil field service costs, reasonable liquidity, and strong historical banking relationships. Our assumptions are based upon a $60-65/bbl full year average for oil. However, if $60-65/bbl or lower oil prices extend into 2016 many issuers may face difficult liquidity conditions and the potential for defaults will substantially increase. The oil field services sector could see elevated defaults in 2015 as earnings come under more immediate severe pressure as pricing and utilization weakens due to independent energy companies reducing their capital budgets in response to lower oil prices. It is worth noting the earnings impact is more likely a 2QTR-2H15 event, as there is a three to six month lag to when independent energy companies adjust their capital budgets. We do not expect material default risk in either midstream companies or refiners as a result of the lower oil price environment.
Recent Energy Supply
No sector has ever issued so much dollar volume in the high yield market over such a short period of time. Due to the US energy “revolution”, high yield energy companies’ capital expenditures far outpaced cash flow, hence, the record supply and now resulting performance pressures at current oil prices. Since the financial crisis, 230B of high yield energy supply has been issued, including north of 50B in each of the last three years. Excess? Not only has the volume of issuance been significant, the growth in the number of unique issuers has also been significant, increasing by over 30% since year end 2011 to 193 unique issuers. Energy related issuers were historically higher quality, today CCC rated and below energy issuers now comprise approximately 10% of the energy sector.
High Yield Market ex-Energy
The broader high yield market has been significantly impacted by the energy sector performance. Below are returns, yields, and spreads of the broad high yield market, energy sector, and the broad high yield market ex-energy. The energy sector has returned -12.90% since June 30, 2014, pressuring the broad market to return of -2.96%. Further, the recent sell off in the high yield bond market has created dislocations and opportunities in non-energy related issuers. The broad market ex-energy returned -1.14% second half of 2014, and now yields 6.21% an increase of +121 bps. Generally speaking, corporate balance sheets remain healthy and supportive of the high yield market, and spreads have become more attractive given solid fundamentals and low current and expected defaults. For the vast majority of the high yield market, the decline in oil is a benefit to either end demand or cost inputs and should help sustain healthy fundamentals. However, oil price volatility will persist and relative value opportunities will continue to emerge not only within the energy sector but also the broader high yield market.