Rising inflation has emerged as a principal risk to the global economy and commodity price recovery has been a significant driver thereof. Energy inflation has soared and reflects a scarcity across all physical markets. The reverberation throughout the supply chain has only begun.

Crude markets continue to rapidly rebalance while OPEC gradually unwinds its production cuts and U.S. producers adhere to capital discipline-driven supply restraint. WTI now trades above $80, its highest level since late 2014. Below average inventories, rising LNG exports, and supply constraints have pushed Henry Hub natural gas prices near $6/MMBtu, while European and Asian gas prices are at record highs. With heating season approaching, a colder than normal winter may exert further upward pressure on prices. Higher natural gas prices typically spur gas-to-coal switching by power generators; however, recent mine closings have decreased supply by 40% over the last six years, and the accelerated retirement of coal-fired power plants continues. Instead, a pivot from gas to oil may add an incremental 500,000 barrels per day of demand through the winter.

Capital discipline has considerably reduced oil and gas capital expenditures. For 2021, total capex is projected to be $56 billion, the lowest for the sector since 2004 and significantly below 2014’s record $184 billion. Even with an expected 15-20% boost next year, spending would still be well below pre-pandemic levels.

Renewables growth continues unabated. Solar had a record second quarter and accounted for nearly 60% of all new electric capacity additions in the U.S., while wind provided substantially all the balance. Supply chain challenges have caused significantly higher input costs; for the first time ever, costs are up both quarter-over-quarter and year-over-year across every solar sub-sector. Looking forward, the pathway to net zero emissions by 2050 could cause the prices of cobalt, lithium, and nickel—key inputs for both solar panels and batteries—to rise several hundred percent from 2020 levels.

Year-to-date, traditional energy equities continue to significantly outperform both the broader market and transitional energy equities, with the XLE Index generating a 52% return through October 27th. While valuations have slowly improved, oil and gas producers continue to trade at a material discount to historical averages. As a result, public equity issuance has largely been muted. Private equity investment in traditional energy has decelerated at an astonishing pace: Since 2018, available capital has shrunk from $90 billion to $22 billion, while the number of active firms has declined from 29 to nine.

The liquid bond markets remain accommodative for most energy issuers. The Credit Suisse Energy High Yield Index offers a yield of 5.27%, within 15 basis points of July’s all-time low. Quarterly issuance volumes for traditional energy issuers have declined sequentially each quarter this year, though year-to-date issuance well surpasses annual volumes in both 2019 and 2020. Through October 27th, 2021 global green and sustainability bond issuance has exceeded $600 billion, a new record. China and the U.S. are the most active markets for issuers, together accounting for over a quarter of issuance volumes. The Bloomberg U.S. Green Bond Index offers a current yield of 1.74%.

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Despite rising commodity prices, traditional energy equities trade at a meaningful discount versus all other sectors. Improving free cash flow yields may help spur multiple expansion into 2022.

Energy high yield remains undervalued versus other sectors on a rating-for-rating basis.

The reinvestment rate is poised to reach new lows in 2021-2022 as oil and gas producers generate record free cash flow and prioritize debt reduction and the return of capital to shareholders.

Solar and wind projects that have been placed into commercial operation this year account for virtually all new U.S. capacity.

European energy prices have skyrocketed this year, creating a dire situation heading into the winter heating season.

In the U.S., commodity price recovery has accelerated over the last quarter, particularly for natural gas.

Angelo Gordon’s Capital Markets Perspectives

AG Capital Markets Perspectives (“CMP”) provides our portfolio managers’ views on the credit, real estate, and private equity markets. To access this quarter’s CMP and past quarterly reports, please complete the form below.

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