Natural resources power bond markets

For hydrocarbons to flow, so must investment capital. But investors must accurately assess the idiosyncratic prospects and risks of companies seeking finance.

The most significant driver of oil and gas prices has been increasing production and rapid depletion from unconventional wells. At a cost of $4m to $8m apiece, they are believed to have a shorter life than conventional wells, which can cost as little as $1m or as much as $300m if they are offshore.

However, the high rate of initial production generates immediate cashflow, enabling faster payback and allowing some wells to achieve internal rates of return of 80-100 per cent.

Mature companies that aim to maintain production by tapping new reserves and have higher market capitalisations, are typically investment-grade rated and have less exposure to unconventional deposits.

Analysing the quality and longevity of unconventional deposits is therefore an important element of our analysis of issuers in this sector.

Other important factors include expected cashflows, capital expenditure needs, access to capital, and environmental, social and governance risks.

Newer companies in this sector are initially financed through the equity and loan market and, if successful, issue securities in the credit markets. Most new issuers earn single-B ratings, and are attractive if they have a strong likelihood of servicing debt and returning to the market, while companies that have achieved substantial, predictable cashflows are rated investment grade.

Early-stage producers are typically riskier. The quality of deposits is not certain, their operational skills are untested and their ability to manage finances is unknown. Although the risk-reward trade-off better suits both equity and secured-loan investors, young companies with good prospects of success should be considered.

As a general rule, companies that can spread their geological, operating and financial risks and, consequently, diversify cashflows by geography, reservoir, hydrocarbon mix and product market, are attractive.

There are newer companies seeking growth through unconventional plays that are in the middle stages of development. They are usually rated below investment grade, may have less diversification and require external financing and capital markets access.

Companies focused on a specific basin, operating a single or small group of assets similar to project finance operators, or which are in their initial stages of development are avoided.

The midstream distribution play is a bit overlooked in this space at the moment. It is common to see midstream companies in this space – such as Chesapeake Energy, Halcón Resources Corporation, Range Resources, Kodiak Oil & Gas, Whiting Petroleum Corporation, American Energy Partners, Forest Oil and Continental Resources – coming to the bond market to fund land acquisition and drilling programmes.

Typically, such companies are fast-growing businesses with smaller enterprise values and issue into the high-yield market.

Many hedge the risk of price movements across incremental periods up to three years ahead to stabilise expected cashflow, which is used to fund capital expenditures and satisfy investors with cashflow visibility. This group of companies frequently engages in mergers and acquisitions.

Fraser Lundie and Mitch Reznick are co-heads of credit for Hermes Investment Management

Expert view

Jason Hollands, managing director, Bestinvest, says: “Over the long term, asset allocation decisions are a key driver behind differences in the returns between investment portfolios, more so than stock selection. Achieving a diversified asset allocation is also an important way of managing risk. This is not always the best use of time for a financial planner who may not be an investment specialist. Multi-asset funds which allocate across equities, bonds, currencies, alternatives and cash in line with a goal and risk profile, can therefore be a very elegant solution for the client and their adviser, especially where the client’s assets are below the typical threshold required for a discretionary account.”