Last month, Mizuho was excited to host our Fifth Annual Rating Agency Energy Panel Discussions at the Calgary Petroleum Club. The event once again featured a lineup of analysts from S&P, Moody’s, Fitch and DBRS Morningstar focused on the Canadian energy sector across an upstream panel, a midstream panel and a one-on-one discussion with a leading expert from Moody’s on Environmental, Social and Governance considerations in the rating process.
With energy markets navigating crosscurrents including the continuing reverberations from Russia’s war in Ukraine, higher interest rates and concerns around a potential recession, the conversations, hosted by Michael Gorelick, Mizuho’s Head of Ratings Advisory for the Americas, were wide-ranging. Panelists in particular highlighted the credit quality and flexibility of Canadian upstream companies versus midstream operators to navigate the current environment. The following are some of the key takeaways from our discussions:
- Ratings have rebounded in the upstream sector, and may not have much more room to run: Supported by higher commodity prices since the early pandemic lows, and significant debt repayment across the industry, ratings for many of the leading Canadian upstream companies have recovered significantly over the last two years. While there is still limited potential for additional upgrades across the sector, ratings are now largely stable. The near-term direction of ratings for the group is now more likely to be determined by strategic decisions around M&A and shareholder returns, rather than by further balance-sheet repair initiatives.
- Some room for upstream companies to entertain shareholder returns and M&A: Now that most producers have largely achieved their debt repayment objectives, the rating agencies do not expect to have significant concerns with companies entertaining share repurchases, dividends or acquisitions, although they will pay careful attention to how these are funded. Shareholder returns funded out of cash flow, rather than incremental leverage, for example, are unlikely to have any negative implications for credit ratings for companies that have achieved their leverage targets. Moreover, many companies have created some capacity for strategic M&A that is partially, or even fully, debt-financed. The recently announced acquisition by Ovintiv of a portfolio of Permian assets from EnCap, which is expected to be partially funded with debt, is illustrative of this flexibility. Each of the rating agencies promptly affirmed Ovintiv’s investment grade ratings and outlooks despite the expectation of a temporary increase in leverage.
- Midstream companies are generally more stretched and have less financial flexibility: Although some of the leading Canadian midstream companies are among the largest in the industry and benefit from strong and stable cash flows, this group carries significant leverage relative to their ratings and has limited additional debt capacity. Developing new midstream infrastructure in Canada has been difficult for a number of years, and several prominent projects have encountered construction delays and very sizeable cost overruns. Consequently, the agencies are closely monitoring how companies manage through these challenges, along with how cash flows ramp up when projects are completed and the ability for certain issuers to reduce leverage over the next couple of years. Against this backdrop, the agencies indicated that they will not have a great deal of patience with companies deviating from their deleveraging paths via shareholder returns or acquisitions.
- Higher interest rates impacting upstream and midstream companies differently: Given recent deleveraging in the upstream sector and the continued focus on free cash flow generation, rating agencies do not have significant concerns around the direct impact of higher interest rates on oil and natural gas producers. As a group, these companies currently have modest leverage, often with debt/EBITDA in the 1 – 2x range, and little floating rate debt. As a result, the impact of higher interest expense is generally not material. In contrast, midstream issuers typically carry debt burdens that can reach 4-6x EBITDA or higher. While this group also tends to have mostly fixed-rate debt, which delays the impact of higher interest rates, interest expense can increase substantially as debt is refinanced. To date, the impact has been limited, but may become a greater concern if rates remain well-above their ranges of recent years.
- Moody’s continues to refine their assessment of ESG risks for energy companies and will roll out new products in 2023: Swami Venkataraman from Moody’s discussed the agency’s ESG journey over the last several years, highlighting the completion in late-2022 of their rollout of ESG Credit Impact Scores for nearly 6,000 issuers globally. This scoring system was introduced in 2021 to highlight the direct impacts on an issuer’s credit rating of ESG-related factors. In addition, Swami discussed other products Moody’s has introduced in recent years, including a Carbon Transition Assessment Tool that was launched in 2019, and a proposal to introduce a new Net Zero Assessment product for which Moody’s published a “Request for Feedback” in November 2022. Together, these and other Moody’s initiatives are designed to help companies better appreciate how ESG factors impact their credit and how they stack up versus peers. In addition, investors are able to use these resources to assess ESG risks across their portfolios.
For more information as to how Mizuho can advise your rating agency strategy, please reach out to Michael Gorelick, Mizuho’s Head of Ratings Advisory for the Americas at [email protected]
Conclusion and acknowledgements:
A sincere thank you goes out from Mizuho to all of the panelists, including:
Upstream Panel:
Michelle Dathorne, S&P Global Ratings
Whitney Leavens, Moody’s Investors Service
Mark Sadeghian, Fitch Ratings
Ravikanth Rai, DBRS Morningstar
Midstream Panel:
Mike Grande, S&P Global Ratings
Gavin MacFarlane, Moody’s Investors Service
Tom Brownsword, Fitch Ratings
Environmental, Social and Governance Discussion:
Swami Venkataraman, Moody’s Investors Service