Value in the global energy sector
Technology recasts the global energy market, providing opportunities in corporate bonds
Advances within the energy market and several years of challenging oil prices have created pockets of opportunities for fixed income. To capture these, we have an overweight position in energy in our portfolios. We particularly favour select exploration and production (E&P) companies, where management teams remain focused on reducing outstanding debt, and a handful of midstream companies, whose cash flows are well supported by stable, long-term agreements and where leverage continues to improve.
Shorter-cycle onshore projects
Lower E&P costs have shifted global crude oil supply and capital investments toward shorter-cycle onshore projects.
Improvements in reservoir imaging, directional drilling and hydraulic fracturing have materially lowered the exploration and development costs for crude oil and natural gas production. These have also significantly improved drilling efficiencies. For some producers, well costs have declined by as much as 70% from the recent peak of the oil market in 2014. Similarly, drilling times have dropped from approximately 60 days at the onset of horizontal drilling, to less than 10 days, while lateral lengths drilled have increased tenfold from under 1,000 feet to ~10,000 feet in some cases. This has driven capital investment away from high-priced, long-cycle offshore projects as lower cost, short-cycle onshore opportunities materialised, particularly in North America.
Integrating data is key to improving costs
E&P companies are still in the early stages of integrating drilling, completion and production data into operations, which will improve cash margins further. Advances in horizontal drilling have so far primarily been mechanical in nature. However, E&P companies are now in the early stages of using digital drilling and completion data. Above ground, producers are gaining economies of scale through centralised pad drilling, where they can drill multiple wells into multiple formations from a single location. Energy service companies are responding by upgrading their drilling fleets with higher specification, self-walking rigs designed to reduce relocation times. In addition, newer rigs have automated drilling or remote operating features, leading to lower headcount and fewer drilling crews. All these developments are coming together to improve operating costs and stave off pockets of inflationary pressure.
Fundamentals are supporting prices
Improving fundamentals in the global crude oil market are creating a favourable macro environment across the energy sector and keeping oil prices relatively range bound. Three years of under investment among non-OPEC, non-OECD oil and gas producers, deteriorating Venezuelan crude oil production and the upcoming implementation of IMO-2020 are pointing toward a growing crude oil deficit, likely to emerge in 2020/2021.
Lower oil prices and the ongoing financial crisis in Venezuela have significantly curtailed the domestic investment in E&P, which is now materialising as a precipitous drop in crude oil output, down to 1.4 million barrels per day (bpd) from 2.4 million bpd in 2014. OPEC has responded by increasing production by approximately 1 million bpd starting in July, offsetting Venezuela’s decline and partially reversing its production cut of 1.2 million bpd set back in November 2016. With the majority of OPEC members producing at or near capacity, OPEC’s spare capacity is expected to fall below 2 million bpd, which has historically spurred an increase in oil prices. Similarly, limited capital investment across non-OPEC, non-OECD producers has restricted their ability to offset annual natural production declines of 3%-4%. IMO-2020 is also impacting global supply and demand. This imposed ban on the high sulphur bunker fuel used in commercial marine transport is expected to add another 1.5mmbbl/d of incremental demand, as shippers switch to lower sulphur fuel. The confluence of all these issues is quickly evaporating the global crude oil surplus of the past several years, providing price support. Responding to higher prices, producers will add supply with short-cycle projects, capping oil prices over the short to medium term.
Energy companies better shaped for future downturns
Companies are financially stronger than before the oil dip, as management teams are now concentrating on returns-driven capital deployment and maintaining strong balance sheets. The drop in oil prices, starting in 2014, left many energy companies needing to repair their balance sheets in order to restore their share prices and to access the capital markets. Prior to the downturn, management teams were primarily incentivised to grow production at all costs. Subsequently, energy companies have adopted a more conservative approach by deploying capital with a high sensitivity to returns at the corporate level, operating within cash flows and prudently returning capital to shareholders. Now, about 65% of E&P companies have incorporated a returns-driven metric into their incentives formula, while nearly 75% have built-in a debt-adjusted growth metric. We expect this trend to continue as shareholders push for greater financial discipline.
As energy markets stabilise, pockets of value persist
Many energy companies have restored their balance sheets and embarked on a balanced approach to capital allocation. In addition, these companies now have cash margins and leverage levels comparable to pre-2014, as well as the added bonus of conservative financial policies. These point to financially stronger companies going forward. Corporate bond spreads in the energy sector have come in a long way from their early 2016 levels. Spreads for several E&P companies, however, remain attractive, as these companies still have active debt-reduction programmes in place or are looking to passively reduce gross debt levels, as bond maturities come due. The change in role of the US, from a net importer to a net exporter, and price differentials emerging from regional pipeline constraints are providing a tailwind for US midstream/pipeline companies and refiners. Improved efficiency, however, has become a headwind for some land and offshore drillers, as technology-driven improvements have resulted in overcapacity. As a result, we are overweight select E&P and midstream companies whose spreads have yet to reflect the improved underlying fundamentals.
Sources: ASI Fixed Income Research, U.S. Energy Information Administration, Credit Suisse, Barclays Capital, select energy companies (APC, COP, DVN, EOG, MRO, NBL).
View the full Global Outlook publication below:
- Strategic Asset Allocation Outlook
- Corporate profits drive equity performance
- Value in the global energy sector
- From Smart Beta to Smarter Beta
- Improving returns by investing in concession infrastructure funds
- Gender Diversity: an economic and strategic imperative
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