The high yield market is up over 10% year-to-date. Despite the strength of this market, a few notable subsectors have materially underperformed. Chief among them have been natural gas and specialty pharma. The latter is composed of a small cohort of companies that are immersed in the opioid epidemic and face material litigation risk. The former has been subject to a 35% decline in natural gas prices since March 2019, making it one of the few commodities in the red this year. These gas credits screen relatively cheaply based on their ratings, and are primed for a potential rebound should inventories, weather or other factors lead to mean reversion in the price of natural gas. However, I remain skeptical and expect any dead cat bounce would reset shorts in the market and cap material price appreciation.
Natural gas prices have been under pressure for years. Similar to shale oil, this is a byproduct of one of the greatest American success stories of the 21st century — the technological breakthroughs and subsequent commercialization that has led to U.S. energy independence. The U.S. now exports natural gas and has developed a thriving liquefied natural gas industry (a process in which gas is frozen and shipped overseas). The export market, along with the increasing use of gas in generating electricity, provides a strong underpinning for secular demand growth.
Supply has been the big driver of lower prices over the past few years. After spiking to $12 in 2008, natural gas has traded below $3 for the past four years, and currently stands at $2.25. Most high yield gas credits can survive with gas prices at $2.50, but returns on invested capital and free cash flow are anemic. As with any commodity, there is a basic self-correcting mechanism in which oversupply and falling prices lead to production cuts and rising prices, holding other factors constant. However, gas faces the problem of “associated gas,” meaning when a company drills for oil, extraneous gas is also produced and contributes to additional supply. Profitability of that gas is not a consideration since it is produced as a byproduct of oil drilling.
Gas credit ratings have been remarkably stable, but we believe they will come under pressure, particularly as above-market hedges diminish in 2020. Enterprise valuation multiples have compressed and currently provide limited equity cushion, while free cash flow is neutral at best for most companies. The biggest issue facing the group is the substantial amount of refinancing of upcoming bond maturities in the 2021-2023 time frame, estimated at about $9 billion. If fundamentals don’t improve, we could see a number of senior secured bond deals prime the unsecured bonds, a tactic executed by issuers in many other high yield sectors. Gas companies do have some levers to pull beforehand, such as asset or royalty sales. Positive event risk via mergers and acquisitions is limited, but a possibility. When weighing the various puts and takes, we are staying on the sidelines for now.
Drexel University Co-op, Mike Cook, contributed to this blog post and served as a co-author.
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