With dramatic swings in hydrocarbon prices seeming to be the norm over the last five years, credit ratings across the energy sector have come under intense pressure. Many investment grade issuers have fallen into high-yield territory (aka “fallen angels”), and the industry experienced elevated defaults and distressed debt exchanges in both 2016 and again this year. Against this backdrop, Mizuho’s Head of Ratings Advisory, Michael Gorelick, hosted a series of virtual panel discussions for our clients to hear from senior analysts from Moody’s Investors Service, S&P Global Ratings, Fitch Ratings and DBRS Morningstar on the outlook for credit quality across the upstream and midstream sectors of the energy industry, with a focus on Canada.
Over two hours, rating agency analysts discussed a broad range of topics that impact their outlooks including energy prices, M&A trends, Environmental, Social and Governance (“ESG”) and energy transition impacts, the prospects for stalled energy infrastructure projects, the impact of COVID-19 and the status of capital markets access across the industry.
- Commodity Prices Recovering: Rating agencies expect WTI to recover from current levels over the next few years to $50/ bbl or greater, with WCS differentials widening back to their historical range of around $15-$20/ bbl. This scenario is likely to support stable ratings for investment grade and near-investment grade issuers, and lower rated credits may be upgraded if they can restore liquidity.
- Upstream Mergers & Acquisitions to Continue: M&A is likely to continue, particularly in the upstream sector, providing benefits through increased scale, diversification and the ability to lower operating costs. Agencies continue to evaluate such activity on a forward-looking basis, and strategically sound transactions may be given 12-24 months to restore credit profiles. For midstream issuers, some of the agencies have shortened their time horizons and ratings may come under pressure as a result of significant transactions.
- Environmental, Social and Governance Risks in Focus: Rating agencies are taking a long-term view of environmental and social pressures that may impact the industry, but select negative rating actions can already be linked to these concerns. Midstream issuers have faced persistent “E” and “S” challenges hindering development of new pipelines, resulting in reduced growth and excess cost, and this has pressured the upstream sector with wide price differentials particularly in Western Canada.
- Covid Impacts Vary for Midstream: The pandemic has not impacted all midstream issuers the same. Large, investment grade issuers generally have little commodity price and volume exposure, and have fared quite well. Smaller, high-yield issuers often have more exposure to commodity prices and volumetric risk, which has hurt performance. Counterparty risks have also increased across the industry, but most companies have good counterparty diversity and agencies have largely been able to get comfortable with these exposures.
- Keeping a Close Eye on Capital Markets Access: Limited capital markets access particularly for smaller E&P companies has triggered numerous downgrades, and in some cases driven weaker players into the arms of stronger ones. North American midstream issuers face nearly $200bn of debt maturities between now and 2025, and lower rated companies will have to be opportunistic to get in front of these in order to avoid liquidity pressures.
A confluence of trends: notable insights from the experts
Energy price rebound expected
Oil and natural gas prices have been subject to extreme volatility in 2020. It is not surprising that the agencies’ outlooks have also changed considerably from where they were at the start of the year. As markets have evolved recently, the rating agencies’ views have converged and are generally consistent in anticipating that WTI crude oil prices will rebound to around $50+/ bbl over the next 2-3 years. At the same time, reduced pressures on the limited pipeline takeaway capacity from Western Canada into the U.S. has caused WCS differentials to tighten, and they anticipate these differentials will widen back out to the $15-$20/ bbl level in the intermediate term. This return to historically wide differentials is expected to occur as production volumes recover, and to be driven mainly by rail economics, which provides the swing takeaway capacity from Western Canada.
The consensus, if this scenario plays out, is that ratings for investment grade and near-investment grade companies should stabilize, with gradual improvement over the intermediate term a possibility. There may also be an opportunity for more rapid recoveries in ratings for lower rated credits, in particular those rated in the CCC-category. These ratings are typically not driven by operational issues or even unsustainably high leverage, but by challenged liquidity positions as a consequence of near-term debt maturities and looming borrowing base redeterminations. As a result, if these issuers can access debt and/or equity capital markets to alleviate liquidity pressures, there is scope for immediate ratings upgrades in many cases.
Mergers & acquisitions activity on the rise
With M&A activity heating up, we discussed what the rating agencies look for when evaluating the credit implications of these transactions, and how much flexibility companies may have to use debt as part of their financing for such activity. Paresh Chari from Moody’s noted that for upstream companies, “[it] comes down to what does the acquirer get or what does the merger improve? Specifically what we are looking for is an improvement in scale, an improvement in diversity and importantly an improvement in durability… Really, it boils down to do we see a really solid strategic rationale for this and does it really tie to what the long-term strategic plan is for the company? If there is a misalignment there… then we are probably going to look at that differently from the issuer.”
The other agencies concurred that the strategic rationales behind many of the recently announced upstream deals have been sound, including the opportunity to achieve G&A and other operational synergies, increase geographic diversity and increase scale. While these larger recent acquisitions have generally been leverage neutral, each of the agencies noted strategically sound acquisitions that result in increased leverage generally will be analyzed based on a 12-24 month forward view, providing issuers some time to restore financial metrics following a transaction.
From the midstream sector, Ram Vadali from DBRS Morningstar noted that they have not seen much M&A activity, with only a few “tuck-ins” in recent quarters. S&P, Moody’s and Fitch agreed, noting many midstream players have been focused on repairing balance sheets in recent periods, while looking to resolve challenges that have contributed to depressed equity prices.
Interestingly, while each agency agreed on a similar time horizon for deleveraging in the upstream sector following acquisitions, there was a broader range of views with respect to midstream issuers. DBRS noted they are generally comfortable with a 2-3 year time frame for companies to restore credit metrics to levels consistent with their ratings as long as the business implications of the transaction were considered supportive. In contrast, Mike Grande from S&P shared that their perspective on deleveraging had become more conservative in recent years. Whereas in prior years, S&P also afforded midstream companies 2-3 years to reduce leverage, as DBRS Morningstar does, they now take a more cautious approach given pressures on the sector. M&A now needs to be leverage neutral to accretive unless the issuer has ample headroom within their ratings, which is not generally the case. Mike commented that midstream companies have worked hard in recent years to get their balance sheets back in order, and M&A that sets them back would not be reviewed well by rating committees. He further observed that while some consolidation remains possible in the sector, he expects that management teams will be very cautious about taking on incremental risk.
Gavin MacFarlane from Moody’s agreed that their time horizon for deleveraging for midstream companies is generally 1-2 years. He also noted that this timeframe would be even shorter when leverage is incurred in support of large-scale projects where execution risk can be significant.
ESG - Energy Transition will garner increased attention
The last few years have seen a significant increase in focus from both investors and issuers on ESG concerns. The agencies have also dramatically increased their attention to these issues, and the impact on credit quality across various sectors. With the energy industry at the center of the discussion, we were eager to hear the analysts’ perspectives on these topics.
The focus for rating agencies remains squarely on the intersection of ESG vulnerabilities and credit risk. The view of the upstream panelists was that while ESG is increasingly a theme in rating committee discussions, it has not been a major driver of credit quality, and is unlikely to be in the intermediate term. Capital markets access for energy companies does not seem to be materially impacted by ESG considerations now nor is it likely to be in the immediate future.
S&P analyst Michelle Dathorne noted a key exception: in some instances, Canadian energy companies have seen ratings impacted by protracted delays in new pipeline construction. In particular, S&P sees the social activism that has resulted in these delays as combining “E” and “S” factors of ESG, and points out that these delays have impacted the top lines of Canadian heavy-oil focused companies through increased commodity price differentials and volatility. Michelle observed that MEG Energy, Cenovus, Canadian Natural Resources and Suncor have all had ratings come down “in response to volatile top-line prices.” However, she noted that S&P does not expect continued widespread negative credit rating actions as a result of ESG factors. Similarly, Moody’s analyst Paresh Chari said, “most of these [risks] are not material yet to the issuers we cover or are so long-dated that it is hard to crystalize in terms of what it means.”
Among the midstream energy panelists, the agencies’ viewpoints around the impact of ESG on ratings were more varied. S&P’s Mike Grande commented that his team is “taking the ESG matters very seriously in Canada and the U.S., ” and that they will likely be a more important part of the conversation over the next 5-10 years. At the same time, he noted that such considerations are not likely to have a major impact on ratings over the next several years. According to him, “[o]ur view longer term is that natural gas and crude oil will be part of the energy solution for the U.S. and the rest of the world for some time to come.”
In contrast, Moody’s Gavin MacFarlane said ESG risk - in particular the challenges impacting development of the Keystone XL Pipeline - was the key risk cited in Moody’s outlook change on TC Energy to negative on March 31st of this year. In Moody’s estimation, credit risks from ESG-related concerns are already impacting ratings. Gavin observed that challenges to infrastructure development has been a key theme for the Canadian energy sector for the last several years.
Tom Brownsword of Fitch noted his firm “is trying to be very balanced when we talk about ESG matters.” He also pointed to the agency’s recent commentary on TC Energy with respect to their delays in constructing the Keystone XL Pipeline, in which Fitch highlighted “the numerous regulatory processes and the extensive environmental studies/scrutiny this project has gone through and passed.” In this same report, Fitch adds “There may be groups who believe the Canadian oil sands are especially bad (for the environment), but Fitch believes that if that oil does not come to the United States via pipeline it will still flow (either to the U.S. via rail or to other countries around the world).”
Taking the temperature on the impact of COVID-19
While the impacts of COVID-19 on the upstream sector have been fairly clear and dramatic, its effect on the midstream sector has been more variable. Tom Brownsword from Fitch Ratings pointed to a significant divide in the industry. On one side are smaller volume-driven players that may also have some degree of commodity price exposure. These companies have been significantly impacted by the pandemic. This is especially true of some of the non-investment grade U.S. issuers. On the other hand, investment grade midstream companies have performed reasonably well as a result of their long-term contracts, which have little commodity price or volume exposures.
At the same time, while counterparty risk has increased for the midstream sector with downgrades impacting many of the upstream companies that they transact with, the agencies noted that this has not yet had a major impact on credit risk. Moody’s Gavin MacFarlane noted his firm had “seen a decline in [counterparty risk in] some areas. In some places it has been a bit more marked than others. . . There is one side which is what do your counterparties look like? But we also sometimes look through that and say if there is an issue with that particular counterparty, what is the quality of the assets? Are you likely to simply see a restructuring and the counterparty continues to produce, which potentially means a limited impact for the pipeline company, or is there something different here where overall production volumes may diminish considerably? It is not as simple as looking at counterparty risk, sometimes you need to look through that.” The other agencies also highlighted that diversification, across a range of counterparties, as well across as a number of assets and regions, can be a significant mitigant to increased counterparty risk.
Capital markets access – the “haves” and the “have nots”
Ensuring access to liquidity is one of the critical roles of any management team, and is even more essential in times of crisis. Many energy companies rely on banks and capital markets to support their liquidity needs, and access to these sources of capital has not been consistent across the industry. Fitch’s Mark Sadeghian noted that market access has been a tale of “haves and have nots,” with this issue not only driving ratings, but also some of the recent upstream M&A activity. In particular, he observed that stronger companies in the sector with better access to capital have been able to acquire smaller industry players with weaker market access for very attractive pricing. Among such transactions, he pointed to Canadian Natural Resources’ acquisition of Painted Pony that was completed in early October. He pointed out that even companies higher up the rating spectrum are having to be more strategic in terms of timing their refinancing requests, and in some cases have elected to wait, looking for a better environment to return in 2021.
Mike Grande noted that North American midstream issuers have around $200bn in debt maturities coming due from 2021 through 2025, although the majority of these maturities corresponds to investment grade issuers that should have less difficulty accessing markets. That being said, Grande pointed out that many institutional term loans to non-investment grade issuers mature starting in 2024. While there could be challenges for some companies to refinance these maturities, he noted that there is still plenty of time for issuers to address these over the next few years.
Conclusion and acknowledgements
Mizuho’s 2020 virtual rating agency energy panel discussion represented the third installment of an annual series we have hosted since 2018 in Calgary. The prior two sessions were in person, and we look forward to resuming in that format in the not too distant future. A sincere thank you goes out from Mizuho to all of the panelists, including:
Michelle Dathorne, S&P Global Ratings
Paresh Chari, Moody’s Investors Service
Mark Sadeghian, Fitch Ratings
Ravikanth Rai, DBRS Morningstar
Mike Grande, S&P Global Ratings
Gavin MacFarlane, Moody’s Investors Service
Tom Browsword, Fitch Ratings
Ram Vadali, DBRS Morningstar
Mizuho’s expert Ratings Advisory team stands ready to advise and navigate companies through the ratings process. Please contact us for a customized and detailed discussion.