After oil price rout, some bond defaults possible
By David Bell
NEW YORK, March 10 (IFR) - The energy sector has been hit hardest by the sell-off in credit markets this week, with investors expecting defaults to climb in the junk sector and even investment grade issuers having to shore up their balance sheets to cope with lower oil prices.
And unlike the last crisis in the energy sector, bond issuers this time may not have access to all the levers necessary to extricate themselves from damaging financial ruin.
The failure of OPEC to reach an agreement with Russia to cut back on production over the weekend has sparked concerns of oversupply at a time when demand for oil is also falling because of the spread of coronavirus.
That has sent oil prices 30% lower with WTI now trading at just US$33.92 a barrel.
"In our view, the outcome of the OPEC+ meeting in Vienna was the worst-case scenario for energy credit and represents a major shift," wrote Barclays analysts in a note on Monday.
The turmoil has stoked growing concerns that US shale developers - which have leaned heavily on the bond market to fuel their growth over the past decade - will be locked out of the capital markets for some time.
The average energy bond dropped by 11.11 points to 64.23 - the most severe decline ever recorded, according to JP Morgan analysts. Some issuers saw their bonds drop by over 40 points.
"I think there are going to be some real bankruptcies here," said one leveraged finance banker. "With the characters that we're dealing with in this country, Saudi Arabia and Russia, these are people that do not back down. This will go on for months," he said.
JP Morgan analysts wrote on Monday that if crude oil returns to US$40 in the second half of 2020, and rises to US$50 in 2021-2022, cumulative sector defaults would reach 24%.
But if prices remain at US$25 and only rise to US$40 in 2021-2022 however, 43% of the industry would default.
"The price point just does not work for US shale," wrote analyst Tarek Hamid in the report.
"Even with energy bonds down over 9% YTD, this is an unmitigated disaster for the sector."
It is not just the junkiest of energy issuers that are feeling the pain.
Investment grade energy bonds widened 130bp to 361bp on Monday, close to their four-year wide.
S&P Global lowered its oil and gas price assumptions on Monday evening and said it would conduct reviews on all investment grade and high-yield E&P and oilfield companies in the next two weeks.
The impact could be more severe than last blowout in energy credit in 2015 and 2016, when many producers cut costs and improved their balance sheets.
They are unlikely to be able to repeat this and are unlikely to be able to raise capital as efficiently as they did back then, according to S&P.
"It's likely rating actions in the investment-grade category could be more severe than during the last cycle," the rating agency said.
High-yield borrowers without price hedges and those with upcoming maturities will most likely face multiple notch downgrades, according to S&P.
But higher-rated companies do have a few more levers to pull to weather the impact of lower prices.
"Energy companies have experience managing through these types of environments," said Nicholas Elfner, co-head of research at Breckinridge Capital Advisors. "Normally what we want to see is for them to cut capital expenditures, perhaps go to a scrip dividend, halt share buybacks."
E&P company Occidental for example said on Tuesday that it would reduce its quarterly dividend to US$0.11 per share from US$0.79, effective July 2020.
It will also reduce its capital spending to between US$3.5bn and US$3.7bn, from US$5.2bn to US$5.4bn.
"These actions lower our cash flow break even level to the low US$30s WTI, excluding the benefit of our hedges, positioning us to succeed in a low commodity price environment," said Vicki Hollub, Occidental's president and chief executive officer.
The company's 2.70% 2022 notes pared some Monday's widening after the announcement, tightening 249bp to trade at 773bp over Treasuries, still way wide of the 172bp level they traded at on Friday.
Diamondback Energy and Parsley Energy, which carry split investment grade and high-yield bond ratings, both announced plans on Monday to reduce drilling activity given the recent volatility in prices.
Parsley had previously expected to generate US$200m free cash flow in 2020 at prices of US$50 a barrel – it is now targeting US$85m free cash flow at US$30-US$35 prices.
"We must act swiftly with an aim to preserve a stable free cash flow profile and remain committed to doing whatever is necessary to protect our balance sheet in the weeks and months ahead," said Matt Gallagher, Parsley's president and CEO.
(Reporting by David Bell Editing by Jack Doran)
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