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Alex Kimani

Alex Kimani

Alex Kimani is a veteran finance writer, investor, engineer and researcher for Safehaven.com. 

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A Wave Of Downgrades Has Hit The U.S. Oil Patch

The riskier end of the energy bond market has lately suffered a sharp blow in response to an epic oil price crash as the coronavirus pandemic and oil price war pushed bonds of oil and gas producers into distressed territory. 

According to a recent Financial Times article, nearly $110 billion of U.S. energy bonds have lately fallen into distressed status, working out to almost 12 percent of the $936 billion in energy junk bonds.

Maybe it's time to go hunting for the rich pickings available in the sector, with U.S. Treasuries dropping to all-time lows.

From a purely technical viewpoint, junk bonds are the same as regular bonds, the only difference being that the issuers have poorer credit ratings.

Investment-grade bonds are issued by companies with low- to medium-risk profiles. These high-quality bonds usually range from Standard & Poor ratings of AAA to BBB. They typically offer lower interest rates because the risk of the borrower defaulting on interest payments is low. 

On the opposite side of the spectrum, junk bonds offer considerably higher yields - historically 4 percent to 6 percent yields above those for comparable U.S. Treasuries - with the current crop of energy junk bonds offering yields above 10 percent, reflecting their high risk of default.

Junk

Source: Investopedia

Bond Pricing and Risk

Junk bonds are generally priced at $100, plus a spread over a risk-free benchmark. Bond prices tend to fall when the markets get choppy, with J.P. Morgan recently declaring any junk-bonds trading  below $70 on the dollar as "distressed." 

The bond markets are currently in 'extreme distress' mode, with the fast-spreading coronavirus keeping investors on edge due to its potential to disrupt global supply chains and trigger a recession. 

The situation is especially dire for the energy sector in the wake of a historic oil price war that has pushed oil and gas prices to multi-decade lows. 

Shale-oil producers have been particularly badly hit, with many struggling to break even when crude was at much higher levels. Consequently, prices of many bonds issued by many shale companies have fallen off a cliff - leading to astronomical yields.

Junk-bond exchange-traded funds also have been recording record outflows amid massive capital flight.

Although wealthy or institutional investors with a high risk tolerance dominate the junk bond market, individual investors can also participate by taking advantage of high-yield bond funds

One caveat: many junk bond funds will only allow investors to cash out after holding the bonds for a minimum of 1-2 years.

Highest Risk Bonds

Morgan Stanley (MS) has warned that, unlike 2016, the risks are no longer limited to the high-yield markets. 

According to the analysts, persistently low oil prices will expose a "significant portion" of the $348B of investment-grade BBB-rate bonds to downgrade and further aggravate strains in the broader U.S. credit market.

MS has picked shale pioneer Chesapeake Energy (NYSE: CHK) and Whiting Petroleum (NYSE: WLL) as the energy companies at greatest risk of default over the near term - meaning in less than a year. 

Triple C-rated Chesapeake has several tranches of junk bonds that have been selling off in droves in the current bear market, including bonds due for maturity in 2025 that have dropped to near $50.00. Chesapeake - the poster-child of shale investments gone sour - borrowed heavily to finance an aggressive expansion of its shale projects. But lately, the company has been running on fumes, teetering on the brink of bankruptcy under a mountain of debt that it's unable to repay thanks to energy prices remaining stubbornly low. 

The company has only managed to get this far through rounds of asset sales (to which management is averse), debt restructuring, and M&A. Unfortunately, it's increasingly clear that no amount of financial engineering will save the former energy giant from going under -  save for another massive asset sale and subsequent value destruction. Chesapeake is now drowning in $9.1 billion of debt, with shareholders equity clocking in at just $4.7 billion. CHK shares have fallen so low that it's now considering a reverse stock split to satisfy SEC requirements.

Meanwhile, Whiting shares have become a sea of volatility, tumbling 84.1 percent YTD after it emerged that the oil-and-gas company was in talks with advisers to refinance its mountain of debt coming due over the next year. The shale producer was recently forced to cut CAPEX by 30 percent in a bid to preserve liquidity. Whiting has a $770M bond maturing next year that is now trading at just $0.24 on the dollar.

The Financial Times has also named Antero Resources (NYSE: A.R.), California Resources (NYSE: CRC) and Gulfport Energy (NYSE: GPOR) among the companies that have kicked off restructuring efforts. 

Antero - which has bonds maturing in 2021 and 2022 as well as a third $750M bond maturing in 2023 which has tanked to $0.32 on the dollar - has, however, denied the restructuring reports. California Resources - with one of its 2022 bonds recently dropping to just $0.04 on the dollar - also seems to be going back on reconsidering restructuring efforts after recently terminating an exchange with noteholders that would have relieved it of $895M in debt and interest obligations. Many debt-ridden oilfield services companies are also junk-rated.

North American oilfield services and drilling companies face a $32 billion wave of debt that will come due this year through 2024 - a daunting prospect considering that oil prices have crashed to nearly 20-year lows. Of these companies, Transocean (NYSE: RIG) has $4.3B; Valaris (NYSE: VAL) has $1.8B, Nabors Industries (NYSE: NBR) owes $1.4B, and Superior Energy Services (NYSE: SPN) has $1.3B of debt set to mature within the next two years as per Moody's.

Other smaller producers that are junk-rated include Denver-headquartered SM Energy Co. (NYSE: S.M.) whose $477m bond maturing in 2022 recently lost more than half its value to trade at 42 cents on the dollar as well as Callon Petroleum (NYSE: CPE) and Laredo Petroleum (NYSE: L.P.) whose bonds are trading at massive discounts.

Fallen Angels

Bonds that once were regarded as investment grade but have since been downgraded to junk status because of the issuing company's deteriorating credit quality are referred to as fallen angels.

Morgan Stanley has picked Occidental Petroleum (NYSE: OXY), Apache Corp. (NYSE: APA), Continental Resources (NYSE: CLR), Cimarex Energy (NYSE: XEC), Noble Energy (NASDAQ: NBL), Marathon Oil (NYSE: MRO) and Hess Corp (NYSE: HES) as fallen angels whose risk profiles are worsening.

Embattled shale company Occidental Corp. has cut CAPEX twice in the space of less than a month to 47 percent below the original 2020 guidance of $5.2B-$5.4B. Triple B-rated Occidental bought Anadarko last year in a $55 billion deal with the company's market cap falling to a quarter of its value before the controversial purchase. S&P Global has threatened to downgrade the company to junk status.

Apache shares have tanked 85 percent YTD after the company announced plans to cut CAPEX by 40 percent, having reduced the dividend by 90 percent. Apache says it will bring its Permian rig count to zero over the coming weeks.

Meanwhile, Noble Energy has joined the long list of energy names that are lowering spending after lowering its spending after announcing a nearly 30 percent cut to 2020 CAPEX.

Still Good To Go

The oil majors have mostly been able to maintain their usually stellar credit ratings with only minor downgrades.

Exxon Mobil (NYSE: XOM) has long been considered the gold standard in the oil-and-gas credit ratings. But that changed [slightly] in November after S&P Global lowered the company's rating to A.A. from AA+ on cash flow concerns.

Chevron Corp. (NYSE: CVX) still has an A.A.- rating by S&P and Aa2 by Moody's even after announcing a 20 percent cut in its F.Y. 2020 guidance for organic capital and exploratory spending of $20B to $16B as well as suspension of its $4B stock buyback program, in a strong response to the oil price crash.

ConocoPhillips (NYSE: COP) remains stable, with a Captive credit rating of "a+". In February, COP added $10B to its buyback program to bring the total allocation to $25B before going back on its pledge in March by lowering buybacks by $2.2B and CAPEX by 10 percent. 

EOG Resources (NYSE: EOG) has maintained its A3 rating on Moody's despite recently cutting CAPEX by 31 percent.

Credit ratings are subject to constant review, so investors need to keep an eye out for any coming changes.

By Alex Kimani for Oilprice.com

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