Currently, the supply and demand dynamic for capital differs significantly for traditional versus transitional energy issuers. Most pronounced on the traditional side is the withdrawal of senior secured supply as regulated lending institutions move away from a sector that has been overbanked for most of the twenty-first century. For transitional issuers, it seems every market is substantially oversupplied, even relative to what are very large demands for capital in each transitional sub-sector. For now, risk is mispriced in many of the capital markets serving transitional energy companies, which are often mere start-ups whose financial forecasts are predicated on unrealistic projections of profitable growth.
Commodity markets remain supportive. WTI has sustained gains above $60 since mid-April, the second longest stretch of its kind since the late 2014 oil price crash. In response to improving demand, OPEC has slowly increased production. Natural gas has traded above $3.50 since late June amid record heat-driven power demand.
Although crude prices have increased over 50% year-to-date, oil and gas producers’ capital discipline remains intact and capital expenditure budgets are largely unchanged. As a result, in the first quarter, U.S. producers generated the highest quarterly free cash flow since the beginning of the shale revolution.
Long-awaited oil and gas sector consolidation is underway, with over $35 billion in upstream transactions announced since April. The realization of meaningful cost savings—key among which is the cost of capital—is the primary goal. All-stock, low premium deals predominate.
Traditional energy equities have significantly outperformed the broader market, returning over 40% year-to-date through July 20th versus 16% for the S&P 500 and -19% for the S&P Global Clean Energy Index. Despite improving valuations, only nine traditional energy follow-on offerings have been priced year-to-date through July, primarily to fund acquisitions. Vine Energy’s March IPO remains the only such offering this year.
The liquid bond markets offer ample capital at low cost for all energy issuers. Credit spreads for traditional issuers have tightened by 75 basis points since March 31st. The Credit Suisse High Yield Energy Index now offers a current yield of 5.5%—40 basis points wide of all-time lows achieved in early July and 120 basis points wide of the broader high yield index. Amid strong investor demand, over $55 billion of traditional energy high yield issuance has priced year-to-date through July—a level that already surpasses annual volumes in both 2019 and 2020.
Green bond issuance is similarly robust, with an expected 32% increase in 2021, representing approximately 10% of total global bond issuance. The yield on the Bloomberg Barclays U.S. Green Bond Index was 1.8% as of July 20th. Bank appetite for new renewable projects is similarly strong.
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Despite materially higher crude prices, U.S. oil and gas producers’ capital discipline has restrained drilling activity. Rig count is significantly lower than it was when crude last traded at current levels in 2018 and 2014.
In the first quarter, U.S. oil and gas producers generated the highest quarterly free cash flow since the beginning of the shale revolution.
The largest lenders to the energy sector have been the most aggressive in reducing exposure, with $18 billion of loan reductions from Q1 2020 to Q1 2021.
Despite the recent correction, traditional energy equities have significantly outperformed both the broader market and transitional energy equities.
Gas demand increased, as its recognition as the primary transitional fuel source has taken hold. Angelo Gordon recently pioneered the first non-bank sustainability-linked loan for a Rockies dry gas producer.
Natural gas prices are trading at multi-year highs amid searing summer heat, constraining supply and accelerating liquefied natural gas exports.