Many North American energy companies have borrowed significantly in the public debt markets to finance their operations, and many of the high-yield bonds in this space have lost value in recent months. As the price of oil has fallen, the economics have changed for these companies. At current price levels, profit margins are squeezed.
Still, within the energy sector, the impact of the price volatility varies.
The Wall Street Journal reports that U.S. oil and gas companies have increased their borrowing by 55% since 2010, to an amount approaching $200 billion. Extracting and moving oil and gas is capital-intensive, so this debt is necessary for exploration and production (E&P) companies, and transportation companies, in particular.
As the price of oil has fallen, the economics have changed for these companies. At current price levels, profit margins are squeezed. Therefore, many of the high-yield bonds in this space have lost value in recent months.
The type of company varies within the sector
Within the sector there are E&P companies that extract energy from the ground, service companies that support the E&P companies, and transport companies, such as pipelines, that move the product. Of these, E&P companies face the most direct consequences of the price drop. Service companies, especially those that support producers with weak profiles, also experience an impact. Transport companies, however, see much less of the effect since energy must still be moved from producers to consumers.
Quality can also vary. Within these segments there are better-run, less-levered companies that should be more resilient than highly levered companies with less liquidity. We take these differences into account when assessing risk in the sector.
The pace of price recovery plays a major role
Should oil prices recover over the next year, we would not expect to see high levels of defaults in the high-yield market. A reason for this is that many companies have hedged their near-term production to lock in higher prices into the future.
However, if oil prices remain at or below $50 for a prolonged period of a few years, an uptick in default risk becomes more likely, though the risk would probably remain manageable in the context of historical default levels. We continue to monitor the situation in high yield closely.