Rising oil and natural gas prices have bolstered the confidence of bond investors in the US energy sector amid concerns that war between Russia and Ukraine could remove the second-biggest crude exporter from a global energy market that had been already struggling with a shortfall of supply.
“Oil is the biggest interruption in bonds. There’s a blowout happening for the price for Russian oil, and themes could be longer lasting than supply and demand [for energy], with Ukraine being a symptom of that,” said John Yovanovic, head of high-yield portfolio management at PineBridge Investments.
With events in Ukraine difficult to predict, market participants say it is unclear whether the geopolitical shock in Eastern Europe will ultimately lead oil prices to a permanently higher plateau. But if the rally in crude is sustained, it could provide a flood of cash to a disciplined oil and gas sector that is not easing up on efforts to clean up balance sheets.
The West Texas Intermediate spot price climbed to US$107.69 a barrel on March 3, its highest level since 2014, while the Henry Hub natural gas spot price climbed to US$4.73 per million BTU, well above the US$3.89 average in 2021, according to data from Refinitiv.
“In energy land, all [the companies] work at oil prices anywhere [near] these levels” said Eric Hess, a portfolio manager at Newfleet Asset Management.
Escalation
Investors had already been warming to the sector in recent weeks as prices climbed, with energy bonds outperforming broader corporate credit indices.
Recent interest from investors has squeezed the additional yield on average junk energy bonds to the broader high-yield index to just 0.25 percentage point, from roughly 2 percentage points at the beginning of 2021 and nearly 12 percentage points at the start of the pandemic in 2020, according to ICE BofA.
However, the escalation of conflict between Russia and Ukraine has intensified focus on the sector.
After BP announced on February 27 it would dispose of its 19.75% stake in Russian state-controlled oil company Rosneft, the company’s bonds mostly held their value. As a result of the sale, BP will lose dividends from Rosneft and its higher-margin oil production, but investors may have applauded the removal of BP’s exposure to Russia, said CreditSights analysts.
Bonds tied to US liquefied natural gas exporters such as Venture Global and Cheniere Energy Partners have also rallied since the outbreak of the war.
They are likely to benefit from the increased LNG shipments to Europe as energy importing countries such as Germany look to curtail their consumption of Russian gas and oil. LNG made up 43% of Europe’s gas imports in December, with the US providing over a third of those shipments, according to Cheniere. US market share has continued to grow, rising to 45% of European LNG imports in January.
The 3.25% 2032 senior secured notes by Cheniere Energy Partners rose to a cash price of around 95 on Thursday, up from 92.50 on February 24 when Russia invaded Ukraine.
“The takeaway is that it’s broadly positive for the LNG complex. At the same time, most of their facilities are highly contracted, so you’re not going to realise the same benefits as an oil producer will,” said Hess, though he said the LNG exporters still had capacity to sell in the natural gas spot market.
Balance sheets
Investors said they are also encouraged by signs that US producers are taking better care of their balance sheets than they have in the past.
Oil and gas exploration and production companies such as Range Resources have tapped capital markets where possible to refinance debt at lower costs, as well as cutting back on capital expenditures and using cashflow to pay down debt.
Independent exploration company Diamondback Energy said on February 22 it will return US$515m to shareholders through dividends and share buybacks. Reducing debt has also been a focus.
On Thursday, the company issued a US$750m 30-year senior unsecured note at 4.25% to refinance bonds. The company's CEO, Travis Stice, said in a February 22 earnings call that the company had no ambitions to place growth above returns to shareholders, in light of elevated oil prices.
“The days of ‘drill, baby, drill’ are long gone," said Andrew Bernstein, a research analyst covering the energy sector at Lord Abbett.
Improved access to capital markets is part of the reason why Fitch expects the energy sector default rate to fall to 1% in 2022, the lowest since 2014.
Still, many bond buyers remain mindful of the industry’s chequered past that has seen several boom and bust cycles in recent years.
"[Energy] is the biggest part of the HY index and tends to be among its most volatile," said Greg Zappin, portfolio manager at Penn Mutual Asset Management. "It has seen some significant distress over the last five years."