Warning Sign: High-Yield Bonds Drive Energy Sector Growth

Posted by Greg Trauthwein October 7, 2014

Energy companies have become a larger presence in the US high-yield bond market this year, relying on debt to fund capex as they expand exploration and production activity, but months of heavy issuance and weaker oil prices are taking their toll.

Some recent bond deals have struggled to get across the line, only to end up still getting punished in secondary.

Apollo's US$1.1bn LBO bond for Jupiter Resources, for example, has traded as low as 89 - even after coming to market last month with a five-point discount.

"A lot of high-yield energy companies, particularly those developing shale plays, are spending more money than they are taking in," Patrick Faul, head of research at Calvert Investments, told IFR.

"They have to borrow capital to fund their planned development of the fields," said Faul, adding that most do not have the ability to use internally generated cash flow.

In the race to develop shale fields, the industry overall has increased E&P spending in 2014 around 6%-8% year-on-year, according to Western Asset Management Co - and much of that is funded with high-yield paper.

WAMCO said energy borrowers have already accounted for 19% of high-yield debt printed this year, well up from 13.8% for the whole of 2013.

In September alone, energy and power made up 25.75% of total issuance, SDC data shows.

"We've seen so much supply from E&P companies," said one high-yield investor. "(It) is sending a bit of a red flag."

MORE DILIGENCE

Yet it's more than just the sheer volume of deals that is rattling nerves on the buy-side.

Stalling demand from China has fuelled a steep drop in commodity prices. The WTI crude future for November has dropped to 89.40 from the 100.07 on July 25.

The investor said he is skeptical about the E&P sector's business model overall, raising concerns that access to debt capital markets might get tougher for some borrowers.

"They know they will have to come back to the debt markets to finance capex plans, but there is a risk that when energy prices fall, they cannot access the market," he said.

Perhaps the most glaring example of that is Energy Future Holdings, the former TXU, which was taken private in 2007 in what was then the biggest leveraged buyout ever.

The company's fortunes reversed suddenly when natural gas prices plummeted. It filed for bankruptcy this year, and investors figure to recover little from the restructuring.

Bankers say the buy-side is also now paying more attention to the capital structure of deals, as well as details about ownership and areas targeted by the E&P activity they fund.

Apollo's Jupiter bond, for example, was pulled out of the market in August after being met with investor push-back over what were seen as overly aggressive terms.

When the trade was resurrected the following month, its covenants were changed, and it was downsized - meaning Apollo had to pump in more equity.

It also came with a juicier 9.25% coupon, almost 200bp wider than 7.50% area whispers.

"The restrictive covenants in the preliminary terms for the bonds (allowed for) significant debt that can be secured ahead of these bonds," said Anthony Canale, head of high-yield research at Covenant Review.

Another market source said investors were "particularly concerned" about that issuer's flexibility to add more debt. He referenced the poor performance of unsecured bonds issued by sector rival Samson Resources, owned by KKR, when it piled on more debt.

CARRYING ON

Energy bonds were the second-worst performing high-yield sector in September, down about 2.24%, according to Citi. Naturally, that has had an impact on new issues.

California Resources, which came to market the same week in September as Jupiter, priced its US$5bn trade three-tranche bond at the wide end of talk as investors demanded a premium for the big size of the deal and the area it operates in.

The bond financed the spin-off of the business from Occidental Petroleum Corp.

"It's not the Permian basin and, because of the spin-off, its area is limited to California. As a result it needed to pay more," said the market source.

But the trade wasn't a disaster. It may have cost the company a bit more, but it still attracted an US$8bn order book.

Bankers are now looking ahead to a similarly sized issue for Single B rated Dynegy, tipped to come to market in the next few weeks to partly finance its acquisition of coal and plants from Duke Energy and Energy Capital Partners (ECP).

CreditSights is positive on the new Dynegy issue, despite investor worries it will re-price the company's outstanding curve and broader concerns about softer prices.

"The biggest risk to Dynegy remains weak natural gas prices and a potential drop into the low US$3s," CreditSights said, "but this (M&A) deal gives the company more fuel source diversity."