The 5 Phases of US High Yield Energy

January 30, 2024

The high yield energy industry has evolved notably over the last 10+ years, the results of which mean the sector now offers investors a high-quality and consolidated investment universe. We discuss the various phases of the sector’s evolution and what this means for positioning in our portfolios.

EXPANSION PHASE

During the period of 2009 through mid-2013, the energy sector was viewed as a higher-quality sector within the high yield universe, driven by supportive oil prices, high asset value in the exploration & production (E&P) subsector and stable cash flows in the Midstream subsector. Spreads in high yield energy were inside the broader high yield index (Fig. 1).

These constructive conditions supported an expansion of the energy sector’s representation in high yield which grew to over 14% of the high yield index. This was largely driven by new issuance of small cap/private E&P companies to fund ambitious growth. However, as a result credit quality deteriorated (Fig. 2).

DEPRESSION PHASE

High yield energy spreads began to underperform in the second half of 2013. Then came the oil price massacre of Thanksgiving 2014 when Saudi Arabia decided to no longer support oil prices as the largest supplier of oil. Spreads responded with significant underperformance (Fig. 3).

The ensuing 7 years were difficult. Defaults dominated the 2015-2017 period and recovery rates were poor. The investment grade cohort was also not immune as there was a wave of fallen angels (Fig. 4).

COVID-19 PHASE

COVID-19 triggered an historic event when the price of West Texas Intermediary (WTI) fell below zero and spreads gapped materially. Prices and spreads did retrace but the lockdowns kept a lid on a more meaningful recovery.

The impacts from COVID-19 lockdowns led to another wave of defaults and fallen angel activity and while severe, it was a quick event largely isolated in 2020. The fallen angels stood out, primarily driven by one large name.

RECOVERY PHASE

The aftermath of COVID-19 resulted in a stronger sector as the weakest companies exited via bankruptcy while higher-quality issues entered as fallen angels. As such, the spread between the sector and the broader high yield market began to compress by the end of 2021 (Fig. 7).

As the industry’s credit quality improved, mostly via attrition, the sector became a higher-quality cohort with lower sensitivity to commodity prices Fig. 8).

Meanwhile, stakeholders (shareholders and bondholders) demanded the E&P industry abandon the reckless spending to fund growth and embrace capital discipline to deliver a more stable business model. Management teams listened and embarked on a lower capital deployment, no growth approach and this led to debt repayment and stronger balance sheets. Credit quality improved and sensitivity to commodity prices became more muted (Fig. 9: Free Cash Flow and Leverage are indications of sensitivity to changes in commodity prices).

CONSOLIDATION PHASE

The energy sector has been in a consolidation phase for several years. The E&P sector dominated the merger & acquisition (M&A) activity. This was due to the highly fragmented nature of the industry which was dominated largely by private equity sponsors and founder backed private operators. In 2023, M&A activity accelerated materially from a transaction value perspective as the larger companies began to merge (Fig. 10).

Meanwhile in the Midstream sector, following a wave of corporate restructuring of the MLP model to the more traditional C-Corp structure, corporate M&A picked up in 2021 and continued in 2023 (Fig. 11).

POSITIONING

The energy sector has been in a consolidation phase for several years, but M&A accelerated materially in 2023. We believe the industry will continue to consolidate, particularly in E&P. We view this favourably as a sign of the sector’s maturity and enhanced credit quality. We believe this will lead to a further tightening of spreads and enhanced performance.

In the E&P sector we place particular focus on oil weighted companies as we feel consolidation within the oil sector has greater opportunity. We favour the BB cohort as there are catalysts (M&A) and credit improvement stories (rising stars) that offer attractive value. The B cohort offers some investment opportunities, but largely does not offer attractive value. We see little value in Fuel and Propane Distribution with no visible catalysts.

In Oil Services, we see some value but ultimately the subsector is composed of a mixed bag of companies with decreasing market share. Lastly, the Refining sector is exiting an historic profit period that will result in earnings degradation and we see structural headwinds with EV transition.

CONCLUSION

The high yield energy sector now represents a higher quality investment opportunity. The sector has well survived a challenging environment over the last ten years, but it remains highly relevant with a large representation in the broader high yield Index. The high yield energy subsector mix has evolved favourably over time. It has become more stable and predictable as the E&P subsector has become smaller than Midstream on a market value basis (Figs. 13 & 14).

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of January 2024 and may change without notice.

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Index Descriptions

J0A0 - The ICE BofA ML US Cash Pay High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt, currently in a coupon paying period that is publicly issued in the US domestic market.  Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

J0EN - The ICE BofA ML US Cash Pay High Yield Energy Index is a subset of the ICE BofA ML US Cash Pay High Yield Index (J0A0) including all securities of energy issuers.

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