Higher commodity prices and fallen angels drive tighter spreads
Energy high yield spreads widened to record levels in February 2020 with the onset of the pandemic and the collapse in oil prices. Over the last 12 to 15 months, spreads between the energy sub-sectors and the broader high yield market – where many energy companies reside – have compressed significantly, thanks to a combination of higher commodity prices and fallen angels.
High yield energy corporate bonds currently provide a spread premium of around 73 basis points (bps) relative to the broader US high yield index, which is toward the lower end of a volatile range that includes spikes as high as 1000 bps in 2016 and almost 1300 bps in 2020 (Exhibit 1).
Bonds issued by both midstream and exploration and production (E&P) companies exhibit spreads that are about 32 bps wide of the broader US high yield index. While this is still relatively wide for midstream spreads, it’s much tighter than recent history for E&Ps, which are benefitting from an improved ratings profile mix due to the inclusion of fallen angels from the investment grade market. Spreads in the oil field services sector are still wide compared to historical levels; oil field services companies are dependent on capital expenditure from E&P companies, which has been lower during their recent focus on maintenance rather than growth.
Source: Goldman Sachs Asset Management, Bloomberg Barclays. As of June 28, 2021.
Stable commodity price outlook
We see support for both oil and gas prices in the near term. WTI Oil is once again over $70 per barrel (bbl) – up almost 50% year to date – supported by recovering demand from economies reopening and industry-wide supply discipline.
Natural gas demand has been supported by rising liquid natural gas (LNG) and Mexican exports and natural gas is likely to benefit in the energy transition because it is viewed as an intermediate fuel. Natural gas liquids (NGL) demand strength is a function of strong petrochemical demand. Tight inventories could keep prices high through 2021 before normalizing in 2022.
While we acknowledge the constructive near-term outlook for energy prices, we continue to focus on companies which can survive in an environment of $50-55/bbl WTI oil and $2.75/mcf (thousand cubic feet) gas prices. Overall, we have slightly higher active exposure to natural gas versus oil.
Renewing our energy overweight but refreshing the mix
After being underweight energy in 2019 and very modestly overweight in 2020, our high yield strategies are now overweight in energy by the same amount as in 2018. But the 2021 re-mix reflects changes in the sub-sectors and our outlook for the energy industry.
Across the E&P sector, we are overweight primarily through positions in fallen angels and large companies. These higher quality companies have greater scale, attractive asset bases with better cost structures and lower free-cash-flow breakevens. Many also feature stronger balance sheets and good governance among management teams. High-quality E&P companies generally have superior environmental, social and governance (ESG) strategies driven by better climate data and financial disclosure, more stringent emission targets and a well-defined plan to reduce carbon emissions.
In legacy E&P high yield issuers we have a higher exposure to natural gas companies, as natural gas has a lower carbon footprint and is expected to play an important role in the climate transition as the global economy moves towards renewable energy sources longer term.
The midstream sector, which we view as relatively higher quality due to the stability of commodity volumes flowing in the system and limited commodity exposure, is our largest overweight. This is a notable difference from our modest overweight positioning in the sector in 2018. We have more exposure to propane and LNG distributors, which are considered relatively cleaner molecules. LNG is expected to play a key role in the transition to future technologies like hydrogen, which is still in the nascent stages of development.
Our overweight to the oil field services sector is also a notable contrast to our neutral position in 2018. With spreads still wider than most other sub-sectors we see opportunities for risk-adjusted reward and are focused on selective higher-yielding companies where discounted bonds leave more upside potential, lower loan-to-value (LTV) ratios and positive near-term catalysts.
Across the refining industry we continue to see sub-scale assets with high earnings volatility. As a result, we have gone increasingly underweight since 2018.
“Companies with exposure to natural gas – which is seen as an intermediate fuel in the transition to renewable energy – may have an advantage."
— High Yield Research Analyst
Goldman Sachs Asset Management Forum | June 2021