S&P Global Ratings has recently observed contracting bond tenors and widening spreads for North American oil and gas debt issuers, relative to those of European peers and the broader corporate fixed income universe, suggesting that investors' growing focus on ESG and credit risk may be affecting demand for new issuance from oil and gas companies. Furthermore, rising stakeholder support for greater investment by oil and gas companies in renewable energy infrastructure has compelled changes in board compositions and institutional investor divestments. Even though investors' growing ESG mandates may be starting to lead to less-favorable financing conditions for the energy sector, bond market investors' appetite for new paper was more than sufficient for investment-grade North American oil and gas issuance to reach a new high in 2020.

Oil And Gas Companies Have Faced Higher Funding Costs Than The Broad Market In Recent Years

Ever since late 2014, when booming U.S. oil production, rising energy efficiency, and OPEC actions to gain market share contributed to a sharp plunge in global oil and gas prices, investors have expressed elevated concern about credit risk in the oil and gas sector. In 2016, credit spreads for investment-grade bonds from the oil and gas sector were 112 bps wider than the average investment-grade spread. Although this gap narrowed in subsequent years, the oil and gas sector faces persistently higher-than-average funding costs.

With the onset of the COVID-19 pandemic and the collapse in oil prices in early 2020, credit spreads for the oil and gas sector reached new heights. In March 2020, the option-adjusted spread for our investment-grade oil and gas composite briefly surpassed 700 bps, more than double the average spread for an investment-grade nonfinancial issuer, after OPEC+ announced that it had failed to reach an agreement to slow production (see chart 1).

Chart 1

Following the fiscal and monetary policy responses from the U.S. government and the Federal Reserve, financing conditions quickly improved in the broad market, particularly for investment-grade issuers. By the end of 2020, spreads had narrowed back below pre-pandemic levels (see chart 2). While spreads for investment-grade bonds from the oil and gas sector also returned to pre-pandemic levels, they remain modestly wider than the investment-grade composite spread, with the average bond spread for the investment-grade oil and gas sector holding approximately in line with that of a 'BBB' issuer.

Chart 2

Since 2017, a growing share of new investment-grade issuance has a maturity of more than 10 years as many companies have sought to lock-in low funding costs. Over the same period, the share of new issuance from the North American energy sector with maturities of that length has shrunk. In 2018, almost 75% of new issues from the energy sector had a maturity of more than 10 years, but this share sharply dropped to less than half of new issues in 2020 and 2021. While many factors could have led to the shortening tenor of energy sector issuance, one possibility is that investors may be less willing to extend longer-term financing to the sector amid ESG concerns, and perhaps uncertainty regarding the role of oil and gas in the energy transition.

Chart 3

Based on these trends in the oil and gas sector, we looked into whether issuers may be starting to face different funding costs based on their environmental impact. This led us to group North American issuance of energy companies (including investment-grade companies from the integrated oil and gas and midstream energy sectors) according to the relative carbon intensity of the issuer, based on their carbon-to-revenue footprints (annual metric tons of carbon emissions per million U.S. dollars of annual revenue), which are calculated by S&P Global Trucost and are used as part of the framework for assigning weights in the S&P 1200 Carbon Efficient Index. Using these metrics, we grouped issuers into quartiles based on their relative carbon intensity to compare recent issuance trends.

We see evidence that issuers with lower carbon intensity were able to issue longer-dated debt at lower financing costs than their more carbon-intense peers (see table 1).

Table 1

This led us to further analyze the new issues from Jan. 1, 2019, to May 10, 2021, from the North American energy issuers to test if differences in the composition of new issues from those in the top and bottom quartiles could explain the differences we saw in the averages for new issue debt. By estimating the cost of new issue debt during the period for the issue rating, tenor, and carbon intensity of the issuer, we are able to estimate new issue yield curves for the average issuer in the top and bottom quartiles (see chart 4).

Chart 4

Based on our analysis, we see some evidence that financing costs during the period from Jan. 1, 2019, to May 10, 2021, were lower for the energy companies that showed the lowest carbon intensity, and higher for those with the highest intensity. We estimate that the new issue yield curve for the average North American energy issuer in the quartile of lowest carbon intensity was about 153 bps lower than that of the average issuer in the quartile of highest carbon intensity.

When we controlled for differences in the composition of issue ratings in the top and bottom quartiles, we estimated that the new issue yield on debt from the average North American energy issuer in the quartile of lowest carbon intensity was about 75 bps lower than that of the highest-intensity quartile. Compared with a hypothetical energy issuer with average carbon intensity in the GICS energy industry group that has also sufficiently disclosed its carbon emissions, this 75 bps accounts for a yield that is about 22 bps tighter for the top quartile and a yield that is about 53 bps wider for the bottom quartile.

ESG Factors Are Clearly Moving Front And Center For Stakeholders Of U.S. And European Oil And Gas Companies

Supporting the emerging trend in the new issue yield and tenor data for oil and gas companies relative to the broader corporate universe, recent shareholder actions have clearly demonstrated the growing importance of ESG factors to U.S. investors. At ExxonMobil Corp.'s annual meeting on May 26, shareholders elected three of the four nominees put forward by hedge fund Engine No. 1 to the board of directors, aiming to bring about change in how the company is handling the risks of climate change. Engine No. 1's proposals received support from larger shareholders including BlackRock, Vanguard, CalPERS, CalSTRS, and the New York State Common Retirement Fund. In our view, the funds expect these new directors to bring fresh ideas to ExxonMobil's 12-member board regarding the company's long-term strategy for dealing with climate change and the energy transition. On the same day in May, Chevron Corp.'s investors voted to include Scope 3 emissions (that is, emissions from customers) in the company's carbon reduction targets. These moves clearly signal investors' increasing demand for greater disclosure and push for oil companies to take faster and more meaningful actions to reduce carbon emissions.

In addition to investors, a number of banks have exited or scaled back their exposure to the exploration and production reserve-based lending market--at least in part due to ESG concerns and in part due to poor returns. Several of the largest banks already restrict their financing to exclude funding for projects in the Canadian oil sands and Arctic drilling regions. However, as the global focus on ESG gains momentum, restrictions could likely expand into other regions to help banks reach their own goals of reducing total fossil fuel exposure to align with Paris Agreement commitments, and some recent exits suggest that U.S. shale could have a target on its back. In the past year, banks including Societe Generale, Bank of Montreal, and ABN AMRO have publicly stated their intentions to exit the U.S. onshore oil sector, citing ESG and other risk factors as reasons.

In 2020, reserve-based lending facilities of speculative-grade U.S. issuers shrunk by more than 20% on average, although this was in large part caused by the collapse in oil prices, which reduced the collateral value of oil and gas reserves. However, despite the recovery in prices since then, banks have held back on extending credit to pre-collapse levels, suggesting that bank appetite for the sector remains weaker. While we believe that poor returns and higher recent default rates are primary factors, ESG considerations and the expedited timeline of the energy transition could further limit credit availability. If banks continue to exit from, or reduce exposure to, the U.S. oil and gas sector, the reserve-based lending market is set to face higher lending rates, stricter leverage thresholds, and more restrictive terms.

Governments in some countries are also increasing pressure on companies to reduce carbon emissions. A Dutch court recently ruled that Royal Dutch Shell is partially responsible for climate change, and ordered the company to reduce its carbon emissions by 45% by 2030 compared with 2019 levels. The ruling was handed down despite the fact that Royal Dutch Shell already has in place a net zero emissions target by 2050. Meanwhile, President Biden has identified climate change as one of the four key crises he plans to address during his time in office. So far, he has brought the U.S. back into the Paris Climate Agreement and pledged to cut U.S. GHG emissions by 50% to 52% versus 2005 levels by 2030, and to net zero by 2050. Although there is not yet a specific plan of action in place, it is likely that oil companies will be mandated to contribute to this goal.

How are the supermajors handling the energy transition?

Although all five major oil companies--BP plc, Chevron, ExxonMobil, Royal Dutch Shell, and Total Energies--support the goals of the Paris Climate Agreement and are targeting emissions reductions over the next decade, only the Europeans so far have set net zero emissions targets for themselves by 2050. In addition, only two companies: Shell and Total, have net zero targets for Scope 1, 2, and 3 emissions, which include emissions by their customers, although Chevron's shareholders recently voted to include Scope 3.

There is also difference between the U.S. and European majors in the amount of capital pledged for clean energy projects over the next five-10 years. Chevron has allocated about $380 million per year (on average) and ExxonMobil about $600 million, while BP is planning to increase its annual allocation to $5 billion from $500 million, Shell intends to spend $2 billion-$3 billion per year, and Total has allocated $2.4 billion for 2021.

The oil majors are pursuing a broad slate of clean energy investments in order to meet their emissions reduction goals, including:

• Projects that transform their own operations, such as reducing flaring, electrification of fleets, and carbon capture, utilization, and storage (CCUS);
• Projects that transform their products, such as hydrogen, biofuels;
• Projects that transform their business models, such as electric vehicle (EV) charging stations, renewable power;
• Projects that provide emissions offsets, such as afforestation, wetlands development, carbon credits

So far, the European majors have led the way on projects to transform their business models, while the U.S. players have focused more on their current operations and development of new products for the existing energy infrastructure. In our view, this divergence in strategies could be one of the factors driving the apparent divergence in new issue tenors for North American integrated oil and gas issuance versus that in Europe, which has grown more pronounced since 2018 (see chart 5).

Table 2

Chart 5

While we believe it is still too early to pick winners and losers from a credit perspective, as increased capital spending on clean energy solutions may not generate returns for several years--potentially weakening near-term leverage ratios--it is clear that stakeholders are demanding greater transparency and clearer strategies for dealing with the energy transition. In our view, oil and gas companies will have to figure out how to address the environmental concerns expressed by their stakeholders, or risk the continued widening of spreads and shortening of tenor relative to the broader corporate market. In particular, although the data are still limited, it appears North American oil and gas companies are achieving less favorable new issuance terms than their European peers.

How we incorporate the risk of continued stakeholder pressure in credit ratings

S&P Global Ratings already incorporates environmental risk and potential related stakeholder pressure into its credit ratings. In January 2021, we revised our industry risk assessment for the oil and gas exploration and production sector to moderately high from intermediate. This reflects our view of the trajectory of oil and gas supply/demand and the impact on producers of fossil fuels, given the increasing adoption and transition of renewable energy alternatives to address climate change. While we believe oil and gas will have a place in global energy, encroachment of renewable energy on market share over time will have broad implications for hydrocarbon demand, prices, and producers of fossil fuels. Due to the social and economic risks from climate change, sovereign and local governments globally are enacting stricter policies and regulations while providing industry subsidies aimed at reducing GHG and carbon dioxide emissions from the burning of fossil fuels. The transition and timing of peak hydrocarbon demand, in our view, has and will continue to accelerate due to the COVID-19 pandemic and increasing adoption of ESG investment mandates among global investors and financial institutions. As a result, we believe the risk of reduced investment and capital market access may become more challenging and costly for hydrocarbon producers.

Shortly after the industry risk assessment change, we lowered the issuer credit ratings on U.S. major oil companies ExxonMobil, Chevron, and ConocoPhillips; European companies Royal Dutch Shell and Total SE; and Canadian companies Imperial Oil Ltd. and Canadian Natural Resources Ltd. (CNRL). For more information, see our report, "The Change To The Industry Risk Assessment For Exploration & Production Companies And What It Means For Issuer Ratings," published Jan. 25, 2021.

A Few Companies Produce Most Of Canada's Crude Oil And Natural Gas

In 2020, S&P Global Ratings rated five investment-grade oil and gas companies in its ratings universe: CNRL, Cenovus Energy Inc., Husky Energy Inc., Imperial Oil Ltd., and Suncor Energy Inc. These five produced 56% of Canada's total 2020 liquids (crude oil and natural gas liquids), and 17% of the country's total natural gas. Oil sands production (synthetic crude oil and bitumen) from these companies accounted for 41% of Canada's total liquids production in 2020. Given the high GHG emissions profile associated with oil sands production, capital market participants and other stakeholders are looking to these few companies to meaningfully reduce the emissions generated by their oil and gas operations.

Investor concerns regarding ESG issues have already emerged. In May 2020, Norway's sovereign wealth fund removed Canada's largest oil and gas producers, CNRL, Cenovus, Imperial Oil, and Suncor, from its US$1 trillion investment portfolio, citing concerns over the oil companies' GHG emissions. In April 2021, New York State's pension fund, the third largest in the U.S., restricted its investment in six Canadian oil and gas companies with a large exposure to oil sands development, due to the companies' perceived lack of preparedness for the transition to a low-carbon future. In contrast, Canada's institutional investors, with few exceptions, have maintained or increased their holdings in Canada's oil and gas companies. Canada's top five pension funds' cumulative investment in shares of the country's top four oil sands producers jumped 147% from a year ago, although much of that increase was due to rising share prices. In contrast, the Ontario Teachers' Pension Plan, which has a 2050 net zero emissions portfolio mandate, began reducing its investment in Canada's oil and gas companies in 2018.

With most of Canada's oil production coming from the oil sands fairway, the perception of the sector's contribution to GHG emissions is emerging as a key investment consideration for large foreign equity and debt investors. With the top 10 investors outside Canada in CNRL, Cenovus, and Suncor currently owning 35%, 62%, and 27%, respectively, of these companies' equity, there is the potential that foreign investors could have a meaningful impact on corporate stewardship and governance. With the 2021 annual general meetings for these companies already completed, shareholder challenges similar to what recently occurred in the U.S. should not extend to these companies during 2021.

Canada's oil and gas industry has to play a large role in the country's targeted emissions reduction

In tandem with the doubling of Canada's total oil production between 1990 and 2019, primarily due to the large scale development of oil sands resources, Canada's total GHG emissions remained within a 700-750 megatonnes of carbon dioxide (CO2) equivalent (Mt CO2 eq) range. Canadian oil and gas producers have made significant progress reducing per barrel emissions; however, total GHG emissions from conventional oil and oil sands development increased by 20% and 468%, respectively. Increasing thermal oil production accounted for more than half of the GHG emissions growth from oil sands production.

Chart 6

Chart 7

With oil sands production concentrated in Alberta, this province will have to play a key role in Canada achieving its Paris Climate Agreement targets. In 2019, Alberta produced 38% of Canada's total 730 Mt CO2 eq. Canada committed to reducing emissions by 40%-45% from 2005 levels. This equates to an absolute emissions target of 400-440 Mt CO2 eq. by 2030. In apparent acknowledgement of the need for co-ordinated action to reduce the industry's carbon footprint, Canada's largest oil sands producers recently announced their intention to work together to reduce GHG emissions. On June 9, 2021, the four investment-grade rated Canadian oil and gas companies and MEG Energy Corp., which collectively produce about 90% of the production from the oil sands fairway, announced they had formed the Oil Sands Pathways Net Zero Alliance, with an objective of reaching net zero emissions by 2050. This unprecedented collaboration highlights the importance of the oil and gas industry's role in Canada's ability to achieve its emissions reduction targets.

Chart 8

What if recent financing trends continue?

As illustrated in chart 9, CNRL, Cenovus, and Suncor have total debt of about C$13 billion maturing in 2021 and 2022; all three have publicly committed to continued debt reduction, so S&P Global Ratings expects a meaningful amount of these debt maturities should be repaid rather than refinanced. In the first quarter of 2021, CNRL and Suncor repaid a total of about C$2.3 billion. Although we estimate CNRL, Cenovus, and Suncor will generate positive discretionary cash flow during this period, under our current oil and gas price assumptions, our projected positive discretionary cash flow will not be sufficient to fully repay all upcoming maturities. If hydrocarbon prices outperform our assumptions, these companies should generate greater free cash flow, and accelerate debt reduction.

Chart 9

Beyond S&P Global Ratings' current 2021-2023 forecast period, the Canadian investment-grade rated oil and gas companies have sizable debt maturities. Collectively, CNRL, Cenovus, and Suncor have more than C$32 billion in debt maturing after 2024. If the bond pricing trends observed over the past few years persist in the future, as the energy transition continues to influence bond pricing and yields, financing costs will continue rising. If these medium- and longer-term debt maturities exceed free cash flow generation or funds committed to debt reduction, we anticipate refinancing costs for oil and gas issuers will remain higher than the broader non-financial issuer universe (see chart 1). Furthermore, the observed trend of decreasing bond tenor (see chart 3) would decrease weighted-average debt maturities and weaken capital structures, if investors perceive increasing credit risk associated with environmental risks.

ESG Factors Are An Increasingly Important Driver For North American Midstream Companies

While at first glance it might appear that the upstream industry is the main focus of many ESG stakeholders, it certainly isn't the only one. The midstream industry counts oil and natural gas producers as key customers, processing, transporting, and storing hydrocarbons for the ultimate end user downstream. Midstream energy companies also are addressing many of the same environmental and social issues, including reducing GHG emissions, being a responsible community partner, and addressing climate change and the energy transition, which is a threat to longer-term organic growth.

Community activism and increased regulations and policy changes contributed to two high-profile pipeline project cancellations: TC Energy Corp.'s Keystone XL, which was to transport 830,000 barrels of crude per day from the Canadian oil sands to U.S. refineries on the Gulf Coast; and the Atlantic Coast Pipeline (APC), a 1.5 billion cubic feet per day natural gas pipeline that was cancelled by Dominion Energy and Duke Energy in 2020, after a six year delay and a doubling of costs to US$8 billion from about US$4.5 billion. In the case of APC, the utility sponsors cancelled the project despite a 7-2 U.S. Supreme Court decision that upheld the essential permit from the U.S. Forest Service, which the sponsors stated reflected the increasing legal uncertainty that large-scale energy infrastructure development is faced with in the U.S. Another natural gas pipeline project in Appalachia, the Mountain Valley Pipeline, has faced regulatory and legal challenges related to federal permits that have pushed its in-service date to summer 2022 from the initial date of late 2018 and a cost increase of about US$2.7 billion for a total cost of US$6.2 billion.

That said, midstream companies are striking a balance between their traditional business and low-carbon energy pursuits. The reality is, in our opinion, that petroleum and natural gas will remain a significant part of U.S. energy consumption for years to come as the industry starts a slow march to clean energy sources. According to the EIA's annual energy outlook, petroleum and natural gas accounted for 70% of total energy consumption in the U.S. in 2020. The EIA predicts that by 2050, this will be relatively unchanged, as renewable energy increases to 18% in 2050 from about 10% in 2020, mostly at the expense of nuclear and coal. We believe there will be a need for natural gas not only as a primary fuel but also for backing up renewable sources when they are intermittently offline. We also think it could take decades before electric vehicles make up a meaningful part of the U.S. automobile fleet.

Chart 10

This leads midstream companies to perform a delicate balancing act of being part of the solution to reduce methane emissions and avoid spills and other potential environmental hazards, while at a minimum laying the groundwork for alternative energy investments in the future. The difficulty of building greenfield energy infrastructure assets will make existing assets more valuable, in our opinion, and likely lead to some industry consolidation as the stronger, more diversified companies look to solidify their competitive positions and provide options for their customers.

A path to cleaner energy investment

We expect to see a continued focus on midstream initiatives that could develop and result in low-carbon investments or reduce their carbon footprint in the next few years. TC Energy Corp. recently issued a non-binding request for information to identify investment opportunities in wind energy that could generate up to 620 megawatts of zero-carbon energy to electrify a portion of its pipeline assets in the U.S. TC Energy views this as an opportunity to leverage its existing power business which includes combined capacity of 4,200 megawatts in Canada. The Williams Cos. Inc. signed a memorandum of understanding with Microsoft to transform Williams' energy infrastructure using digital technology to advance the company's net zero emissions goals. Williams set a commitment of 56% absolute reduction in companywide GHG emissions by 2030 and a path to net zero by 2050. Kinder Morgan Inc. formed an Energy Transition Ventures Group to pursue commercial opportunities like carbon capture and sequestration, hydrogen production, and renewable diesel production. In our view, midstream companies will seek to leverage their existing asset base for use in the future renewable energy economy.

With industry headwinds increasing, how the midstream industry pivots to cleaner energy while sustaining the traditional business that accounts for almost all the current industry EBITDA will be a key credit factor for ratings. We revised our industry risk score in January 2021 to reflect increasing environmental and social risks posed by climate change and GHG emissions, and the threat these risks pose to the future production and use of hydrocarbons over the long-term. The industry risk change itself did not result in any ratings changes, mainly because most midstream companies have contracted cash flow and the industry had stronger balance sheets going into the recent downturn caused by the COVID-19 pandemic. However, we believe the existing midstream infrastructure was built to support the expectation of higher levels of production and end-user demand, which is under threat, and might result in lower profits when rates and fees are negotiated in the future. How companies address these challenges will be paramount to our view of industry creditworthiness.

Credit Risk Is Rising For North American Energy Companies

To varying degrees, concerns primarily regarding the 'E' factor in ESG have compelled rising activism from institutional debt and equity investors, reduced lending from banks, and increased government regulation during the past few years. Whether the success of these historic actions will trigger further stakeholder activism is not yet certain, but appears likely. Nevertheless, S&P Global Ratings perceives credit risk for energy companies is rising, which has already led to negative rating actions and could hamper credit rating upside. On the other hand, many energy companies have publicly committed to continued debt reduction, which if executed, could temper the potential adverse effects of evolving industry risks in the near term.