By Kris Rosemann
On January 22, Moody’s placed 120 oil and gas companies (XLE) from across the globe on review for a credit rating downgrade. The list ranges from massive global producers such as Royal Dutch Shell (RDS.A, RDS.B) and Total (TOT) to nearly 70 US exploration and production and services (“E&P”) companies. It also includes 55 mining companies (XLB) that have been punished by the recent rout in commodity prices. Alcoa (AA), Rio Tinto (RIO) and Vale (VALE) are a few notables that made the list for a potential downgrade. The news is not completely unexpected, however, and may likely be a response to several executive teams pointing to legacy (outdated) counterparty/customer ratings as reasons to not be concerned with their own credit quality. We believe Moody’s is seeking to correct this.
The credit rating agency recently reduced its crude oil price assumptions due to expectations for continued oversupply in the global oil markets to ensue. Moody’s expects Iran to add more than 500,000 barrels per day to global supply, and it anticipates many other players to continue to produce “without restraint” as they battle for market share (or survival, depending on cash flow needs). The rating agency expects US oil producers to cut output in 2016, but not by enough to account for the increase in supply from Iran and other unrestrained sources. Moody’s now is targeting both Brent crude and West Texas Intermediate crude to average $33 per barrel in 2016, a reduction of $10 per-barrel and $7 per-barrel, respectively (its forecasts call for $38 per barrel in 2017 and $43 per barrel in 2018). We note commercial crude oil inventories in the US remain at 80+ year highs. The credit agency’s natural gas price assumptions have not changed.
As can be expected, Moody’s points to weakened free cash flow generation as a result of lower realized energy resource prices as the primary reason for reduced credit quality across the E&P space, something the market has been witnessing for some time. The rating agency also noted that projected reductions in capital expenditures by E&P companies will challenge the drilling and oilfield services sector even more than it already has. Moody’s expects the drilling and oilfield services sector’s EBITDA to drop by another 25%-30% in 2016, and even if commodity prices recover, these companies are not likely to regain pricing power due to the excess production capacity that remains in the sector. Even the largest, most diversified drilling and oilfield services with investment grade credit ratings will see their financial flexibility fall and financial leverage grow; drillers with significant contract expirations are worth watching.
One area that we would have liked to see Moody’s pursue is the impact that these downgrades will have on midstream operators (AMLP, AMZ). The events that took place in 2015 revealed the vulnerability of midstream entities to a prolonged downturn in energy resource prices, and we expect the sensitivity to only be heightened as upstream customers suffer potential credit downgrades. Kinder Morgan (KMI) recently announced a large goodwill impairment charge on its core natural gas midstream assets, and operating income performance across the midstream space continues to suffer. The likelihood of many upstream entities to reorganize under Chapter 11 protection in a scenario of an adverse credit event would almost certainly void existing contracts with their midstream counterparts (most pricing would then be renegotiated lower, challenging midstream profit levels). Swift (SFY) marked the 40th E&P to file bankruptcy in the US during this energy market swoon, and there are more to come, with Chesapeake (CHK) being one of the largest that’s on the brink. Of the largest pipeline operators, we would not expect Plains All American (PAA) and Energy Transfer Partners (ETP) to retain both investment-grade status and their current distribution levels once this downdraft of the energy cycle has passed.
The 55 mining companies that found themselves on Moody’s review-for-downgrade list continue to battle a commodity price collapse due to oversupply and economic weakness in China (FXI) and other BRIC nations, including Brazil (which is in recession). The slowing growth in China, where expansion is at its lowest pace in 25 years, has the potential to bring an unprecedented prolonged downturn in the commodity cycle. Moody’s recently downgraded global commodity miner Glencore (GLEN) to one step above junk status as it expects the weak mining market conditions to continue over the next few years. We expect high-yield defaults among the weakest miners to surge as the capacity to service debt wanes. Freeport McMoRan (FCX) is most likely to lose investment-grade status, which had been placed under review for a downgrade earlier this month.
Though Moody’s review “focuses on companies rated in the range of A1 to B3,” we note the agency included that it is “also reevaluating higher and lower rated companies in the context of industry conditions.” ExxonMobil (XOM), Chevron (CVX), ConocoPhillips (COP) and Occidental Petroleum (OXY) were not included on the credit agency’s review list. We continue to expect the strongest integrated players to be resilient in the face of weaker energy resource pricing, but dividend growth will likely be sacrificed to ensure balance sheet health. Among the Big 3 majors (XOM, CVX, COP), we point to ConocoPhillips as most at risk for a dividend cut, and its decision to spin off Phillips 66 (PSX) has only punished those opting for the upstream exposure in the face of the collapse in commodity prices. Chevron, ConocoPhillips, and Phillips 66 had previously been holdings in the Dividend Growth Newsletter portfolio, all since removed prior to the energy resource pricing collapse.
We think the rather sweeping announcement by Moody’s is appropriate, even if it may be somewhat late, as many have been calling for a credit review of several of the most overleveraged energy companies since nearly the beginning of the energy resource pricing collapse. That said, we also understand that it is no small action for an NRSRO to cut the credit quality assessment of an entity, which could increase refinancing risks and debt-service costs, ultimately leading to further trouble, if not a credit event. Though most of the bond markets, particularly in high-yield, have already factored in increased default risks across the energy and mining sectors, the looming credit downgrades may finally hit home to the most outspoken skeptics that “we’re in a market of lower energy resource pricing for longer.” Multi-notch downgrades have not been ruled out.
Industrial Minerals: ARLP, BTU, CCJ, CLD, CNX, HCLP, NRP
Energy Equipment & Services (Large): BHI, CAM, FTI, HAL, NBR, NOV, SLB, TS, WFT
Energy Equipment & Services: CLB, DRQ, FI, HLX, HP, OII, OIS, PDS, PTEN, SPN, TDW
Energy Equipment & Services – Offshore Drilling: ATW, DO, ESV, NE, RDC, RIG, SDRL
Metals & Mining – Aluminum: AA, ACH, ATI, CENX, KALU, NOR
Metals & Mining – Diversified: BHP, CLF, FCX, RIO, SCCO, SLW, VALE
Metals & Mining – Gold: ABX, AUY, EGO, GG, KGC, NEM
Metals & Mining – Steel: AKS, GGB, MT, NUE, PKX, STLD, X, ZEUS
Oil & Gas – Major: BP, COP, CVX, PTR, RDS, TOT, XOM
Pipelines – Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, EVEP, HEP, KMI, MMP, NS, PAA, SE, SEP, WES