In our June Credit Check-In, we discussed how a combination of higher energy prices – WTI Oil had recently risen above $70/barrel – and fallen angels had tightened the spread premium of the US high yield (HY) energy sector relative to the broader US high yield index to just over 70 basis points (bps) from highs of almost 1300 bps in 2020.
Four months later, as economic reopening fuels increasing demand for energy but supply remains constrained, WTI Oil is trading at around $85/barrel and US natural gas prices have risen to $5.5/mcf (thousand cubic feet). However, the most pronounced moves have occurred in the European natural gas market, with prices surging more than 500%, to record highs in 2021.
Higher energy prices will impact credit markets in several ways, which we discuss in this Credit Check-In.
Source: Macrobond, Goldman Sachs Asset Management. As of 25 October, 2021. Brent Crude Oil prices are based on ICE Brent Crude Oil futures contract and the ICE Brent Index. Natural Gas prices are based on NYMEX Henry Hub Natural Gas futures contracts. Trading is in units of 10,000 million British thermal units (mmBtu).
Energy prices plummeted in early 2020 when an oversupplied market was met with a sharp decline in demand as the Covid-19 pandemic struck. In the following months, the energy sector experienced a wave of defaults, restructurings and credit rating downgrades. Since that time, many energy companies have taken important steps to improve their fundamentals, such as prioritizing free cash flow generation over growth and taking a disciplined approach to their operations by maintaining, but not growing reserves. In addition, equity- rather than debt-funded merger and acquisition (M&A) activity has helped improve free cash flow positions and access to capital by creating larger companies with more scale.
The result is improved credit fundamentals and higher quality credits across both the high yield and investment grade (IG) energy sectors. This is reflected in the HY energy spread differential with the broader US HY market mentioned earlier, which has continued to tighten further to roughly 40bps. The current rise in energy prices continues to support these trends and we expect to see a number of fallen angels in the HY market become rising stars as companies return to IG ratings. Roughly $10-12 billion of corporate bonds have migrated to IG through M&A over the past 12 months and we expect around $30-35 billion of corporate bonds in the HY energy sector to be upgraded to IG.
We think integrated oil and gas companies will spend their increased free cash flow in three ways in the near term, which in aggregate, we expect to be supportive of credit fundamentals:
Energy companies will also need to continue to invest for the future. As the energy transition progresses, this spending will look different from previous cycles and vary across regions. For example, spending on greener initiatives has already gained traction in Europe, with some integrated energy companies building renewable electricity generation capabilities. Alternatively, US companies have focused more on early-stage technologies such as hydrogen, carbon capture and biofuels.
Decarbonization is both a risk and opportunity for the energy sector and business models will have to adapt. The steps and the speed at which they are taken will depend on the region, as well as the strength of a company’s balance sheet and cash flows. Better capitalized companies with more financial flexibility may be advantaged to lead the transition.
“The current commodity backdrop provides a windfall for companies with stronger balance sheets and we are watching capital deployment closely.”
— Sophia Ferguson, Lead Portfolio Manager, Global Credit
Goldman Sachs Asset Management Forum | October 2021