Drilling A Bit Deeper into High Yield Energy
With the energy markets seemingly rebalanced and oil prices hovering near $55 per barrel, we have decided to take a closer look at the Oil Field Services sector. This subsector is the weakest link in the energy supply chain as these companies largely rely on exploration and drilling capital expenditures. It was the most distressed energy subsector in 2016 and has been the last to recover. Still, enough has transpired to suggest a potential inflection point in fundamentals in 2018 or 2019, with many of the survivors effectively extending their own runways via opportunistic refinancings. Despite the spread compression in 2017, as seen in this week’s chart, this subsector of High Yield Energy still has higher credit spreads than the overall High Yield Energy sector and therefore is worth drilling into further (pun intended).
The companies that make up the Oil Field Services subsector, as the name implies, provide services to the oil and gas exploration and production (E&P) companies, but do not produce the commodities themselves. This subsector also includes the drillers for offshore and onshore energy production. While these service companies do not have direct commodity price risk, they are actually some of the most levered businesses to the underlying commodity price.
The service companies are the most levered because they require E&P companies to explore for new barrels of gas and oil. In that sense service companies do not control their own destiny. On their behalf, E&P companies will only drill for more oil and gas when prices justifies the action, and so when commodity prices fall their services are the first to get cut. Prices for their services contract sharply, backlogs shrivel, and equipment idles. Within the oil services sector, the offshore drillers face additional challenges in contrast to previous energy cycles, as the ability for E&P companies to produce shale oil has dramatically changed the oil supply situation over the last couple of years. The cost of a barrel of oil from offshore drillers is on the high end of the oil supply cost curve due to cheap onshore shale oil.
At sub $50 per barrel WTI oil, the demand for energy services, especially offshore drillers, is certainly at risk. However, at $50 per barrel many of these companies have been able to access the High Yield Market, albeit at high coupons due to their elevated risk and extension of near term maturities. The terming out of their debt preserves their optionality through the cycle and buys them time for better supply/demand fundamentals to emerge.
In a world where spreads are 400 basis points (bps) in High Yield, an additional 142 bps or 35% pickup can make all the difference. This is especially true in a coupon-clipping year, which is what many high yield strategists often predict at the outset for the coming year. Is it worthwhile taking the additional risk in the Oil Field Services subsector now that we are approaching $55 WTI oil? I would say offshore drillers and energy services have longer runways this time and would be a good place to invest.
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