After exploding from 10% two weeks ago to 23% last Friday, the HY Energy spread to U.S. Treasuries finally looks to have peaked. That’s a good thing, but spreads haven’t narrowed like the equities have rallied this week, suggesting to us the credit market hasn’t bought into the recovery just yet. This will be a key data point to watch, not only as a key signal the sector financial outlook is stabilizing, but potentially for the debt capital markets door to open.
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After a round (and for some producers, two rounds) of downward capex adjustments for 2020, we’re again updating models across the board. Overall, the updated outlooks cut two ways. To the positive, they showed the sector playing defense with budgets mostly coming below expectations to support balance sheets and liquidity (average YE20 Net Debt/EBITDA drops 0.2x turn), but in doing so, they also showed volumes coming in below expectations. That’s the negative and it’s creating a headwind that can persist on the other side of the COVID-19 recovery, as we now see the sector needing WTI to rise above $40/bbl in 2021 to generate positive y-o-y cash flow growth and further de-lever. See updated company estimates within.
While there’s been significant downward pressure on domestic natural gas demand due to the record warm winter and COVID19 shutdowns, consumption for power generation has surprised to the upside so far in 2020. Using Genscape data, estimated YTD natural gas consumption for power generation has averaged 28.9Bcfpd vs. Wolfe’s 27.6Bcfpd 1Q20 estimate and 26.5Bcfpd in 1Q19. This y-o-y increase comes despite a 1% decline in overall power generation output, most likely due increased coal to gas switching as Henry Hub has averaged $1.89/mmbtu YTD vs. $2.87/mmbtu in 1Q19. Further backing up the impact of fuel switching, Genscape has 2020 YTD coal power burn down 40% vs. 1Q19 levels. In our supply/demand model, we estimate power consumption to average 31.3Bcfpd in 2020 (+0.4Bcfpd y-o-y) with similar annual increases in 2021-25 as renewables gain market share. See page 3 for the power consumption data.
For the week, our E&P Index finished -23% vs. the S&P500 -15% and WTI -29%. Stocks continue to trade in a highly volatile pattern, with a 90% spread (yes, 90%) between the top (SWN) and bottom (GPOR) stocks in our index this week, while FANG and CXO, tight Permian peers saw a 20% spread. This means it’s a daily battle to find relative value opportunities, and some of the best opportunities lie across the capital structure. Inside this week, we highlight trends and opportunities we see in credit, address a key question that’s come up regarding credit pricing as it relates to M&A, and give our take on the three-part debt offering that EOG launched Friday morning and pulled Friday afternoon (3/20/20).
For the week, due to the strong Friday finish (3/13/20), our E&P Index miraculously ended -8.1% vs. the S&P500 -8.8% and WTI -23%. We hope you and your family are healthy and everyone is doing ok through this challenging period.
We are updating 2020/21 estimates across our coverage to reflect the current forward oil curve. Further, given all the sector uncertainty, the declining return of capital and growth profile, the stress that balance sheets will feel, and the magnitude of the estimate cuts, we’re moving our Large Cap E&P sector rating down to Market Weight. We see it hard for the E&Ps to outperform outside of a V-shape recovery in crude oil prices, which we view as unlikely. COP and PE are Top Picks and we continue to recommend EQT and COG on the positive natural gas theme.
While the shape of the U.S. oil and natural gas supply outlook is changing daily as updated budgets roll out, we see a portion of the production base acting differently due to the sector’s increased financial risk. Basin location, midstream commitments, and inventory duration are also factors changing forward outlooks, but to get a sense of how much supply could face decline due to growing bankruptcy risk, we added up the production base of 42 High Yield issuers as a proxy. There are a few stable producers in this group, such as PE, WPX, and MUR, but collectively we estimate that a sizeable 2.3mbpd of oil and 29.5Bcfpd of natural gas supply, or 18% and 30% of the current Lower48 supply, respectively, could soon be rapidly declining (and potentially never recover), if capital market access doesn’t open up. See page 5 for the list.
With a +10% move over the past month, front month natural gas has been a relative winner in the wake of the crude oil price collapse, and we believe there continues to be upside support as the supply outlook worsens. Domestically, the clear beneficiaries have been the Marcellus producers, particularly EQT and COG, who have outperformed our E&P Index by 87% and 65%, respectively, over the past 1 month, but with the Haynesville mostly in private hands, we believe investors can also look to Canada for additional natural gas exposure. Within our coverage, OVV and MUR have significant Montney exposure and but we’d also highlight three Canadian producers - Tourmaline (TOU.CN), Seven Generations (VII.CN), and Arc Resources (ARX.CN) - that have underperformed Marcellus peers over the past month, trade at lower EV/EBITDA multiples, and have similar, if not better balance sheets based on Consensus estimates.
For the week, our E&P Index was -18.6% vs. the S&P500 +0.6% and WTI -7.1%.
While E&P credit risk was already growing on COVID-19 demand concerns, the Saudi Aramco announcements this weekend will trigger even more concern. With front month WTI (CL1) down 27% (-$11.25/bbl) to $30/bbl in current trading, well below the $40/bbl downside cases most E&Ps run, every producer will be impacted to some degree. See inside for more details on spreads/pricing for individual credit across the sector.
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