Crude oil trading at its highest sustained level since the fall of 2014 has eased credit concerns for even speculative-grade North American oil and gas producers, S&P Global Ratings said, as the number of companies forced to borrow at high interest rates has collapsed since the pandemic spring of 2020.
"The U.S. distress ratio — the proportion of speculative-grade (rated 'BB+' or lower) issues with option-adjusted composite spreads of more than 1,000 basis points relative to U.S. Treasuries — fell to 2.3% as of June 21, 2021," Ratings said, its lowest point since August 2007 and a contrast to the spring of last year where 95% of junk bond borrowers were paying more than 1,000 points, or 10%, for credit.
Speculative-grade bond issuers that were offering coupons as high as 1,655 basis points in April 2020 are now finding plenty of buyers for bonds selling for 432 basis points or less in June, Ratings said in a July 12 research note.
"U.S. speculative-grade issuance in the oil and gas sector remains robust in 2021, with close to $18 billion of U.S. primary issuance through June 30, as financing conditions remain extremely benign, even for lower-rated issuers," Ratings said. "So far in 2021, speculative-grade issuance in the oil and gas sector is the highest since 2015."
Risk has not disappeared in the junk bond market. The default rate for speculative oil and gas bonds stayed above 20% in June, compared to 9.5% in April 2020, Ratings data showed.
Ratings noted that environmental, social and governance, or ESG, issues will begin to raise the costs for more carbon-intensive issuers.
Restrained capital spending combined with the healing powers of higher oil and natural gas prices will help return several "fallen angels" in the upstream and midstream sectors to investment-grade ratings as early as next year, according to credit research firm CreditSights. "Fallen angels" are companies that have been downgraded from investment-grade to junk status.
"While we don't see this happening in 2021, we are expecting a wave of rising stars over the next couple years if commodity prices cooperate," CreditSights' senior analyst for the high yield upstream and midstream sectors Charles Johnston told clients July 12. "In total, 37% of the [Bank of America Merrill Lynch's] High Yield Energy index could move to investment grade over the next 12-24 months."
"This figure could move even higher when taking into account potential mergers and acquisitions," CreditSights said. "Shale production and the midstream infrastructure to support it have been in growth mode for more than 10 years and it appears that [growth] is largely behind us with infrastructure in place to support modest growth for the foreseeable future."
"The upstream sector seems likely to continue consolidating, which allows for improved drilling and completion efficiency by increasing blocks of contiguous acreage, as well as direct cost cuts like general and administrative, while midstream is likely to join as current projects winds down and acquirers get their balance sheets in order," the research firm said.
Johnston's top upstream candidate to move back to investment grade is the U.S.' largest natural gas producer by volume, Appalachian driller EQT Corp.. In the midstream sector he predicts pipeline operator Targa Resources Corp. will be quickest back to investment grade.
"Targa has the strongest asset base among gathering and processing focused peers, improving credit metrics and offers roughly 20 basis points of yield pickup to Western Midstream Partners LP and DCP Midstream LP," CreditSights said. "In the near-term [Targa's] credit metrics are already within the range to be considered for upgrades at S&P and Moody's."
"With 86% of 2021 production and 42% of 2022 production hedged, EQT has the clearest path to an improving balance sheet among our upstream coverage," CreditSights said. CreditSights said all three credit rating agencies have upgraded or anticipate upgrading EQT to just below investment grade when the driller closes on its acquisition of Alta Resources LLC's Marcellus Shale assets later this year.