Implications for Bonds in Energy Cycle Transitions

Hello, I'm Justin Gerbereux, global head of Credit Research at T. Rowe Price. I'm here today with our investment-grade and high yield energy credit analysts, Elliot Shue and Mike Hyland, to discuss their unique views on credit markets during what should be a period of transition in the energy sector. Historically, energy sector productivity changes with either industry-specific dynamics or economic cycles.

The global pandemic, however, disrupted both the energy sector and the broader global economy, making it less clear where we are in the productivity cycle. Therefore, we are engaged in the current debate of whether signals such as waning productivity gains indicate that the cycle is turning or a consequence of post-pandemic distortions in data. Recent work by our equity colleagues suggests that the productivity cycle in energy may be close to a more secularly bullish phase, meaning we could see a multiyear rally in prices for oil, natural gas, and other commodities. Building on this research, our credit analysts are here to discuss attributes that are unique to their discrete asset classes during periods of energy industry transition. Elliot, using that productivity cycle change as a backdrop, how are you thinking about the investment-grade credit asset class?

<Elliot>So regardless of where we are in the energy or productivity cycle, we're still going to take a same basic approach to credit analysis. We're still going to look at a lot of traditional credit metrics like leverage, coverage, free cash flow generation as a check on company health. So good bottom-up credit work is our good first principle, but we are going to be aware of where we are in the cycles to sort of give context to how those metrics look and add nuance to our valuation view.

So typically in bull cycles versus bear cycles, credit metrics are much stronger. So lower leverage, faster growth, better free cash flow generation, and company results tend to be much less volatile than they are during bear cycles. They also tend to compare more favorably to your generic industrial financial profile. So if we are entering a more secularly bullish phase, then that implies there's room for credit improvement and also implies that there is room for valuations to perhaps rerate and have better direction.

<Justin> Perfect. Thank you for that backdrop. So taking that, how are you currently thinking about the energy investment chain, and what do you find most attractive? 

<Elliot> So simplistically, we are favoring the upstream over the downstream. So the companies that are closest to the initially produced barrel of oil. So these would be companies like independent E&Ps, which drill for the oil and are going to benefit from higher oil prices. And then also the oil field services companies who will benefit from increased capital spending by the E&Ps.

<Justin>Got it. Pivoting you to Mike, how are you using this backdrop to think about investing in high yield credit?

<Mike> Thanks, Justin. Over the past decadelong downturn in energy, high yield energy has traded at a yield premium to the overall market, reflecting the increased risks with companies that are focused on growth over their balance sheets. Post-COVID, management teams have shifted their focus to reducing leverage and generating free cash flow. As a result, high yield energy now trades inside the overall market. 

Indeed, high yield energy has become a defensive sector within the market. Due to this development, high yield accounts have increased their exposure to energy and, similar to our IG counterparts, we are more comfortable with E&Ps and offshore drillers. More broadly, high yield energy as a percentage of the overall market has shrunk and is continuing to shrink as companies improve their balance sheets and get upgraded to investment grade. These are known as rising stars.

<Justin> Interesting. Playing off that rising star theme, Elliot, how are you potentially taking advantage of that within investment grade?

<Elliot> So rising stars from high yield are going to increase the size of the investment-grade opportunity set. And given the nature of transitioning from high yield to investment grade, there can be some high-profile and interesting stories to get involved with. So since 2021, about USD 40 billion of debt has transitioned from the high yield market to the investment-grade market, and that's a high-single-digit percentage of total investment-grade energy debt. And then there are another number of credits, probably about USD 20 billion of debt, and it would be a mid-single-digit percentage that could, still are yet to come back to the investment-grade universe. So generally it broadens the opportunity set and gives a lot of opportunities for us to focus on some interesting stories given the current view on the energy cycle.

<Justin> Perfect. Mike, Elliot, thanks for joining us today and sharing your views. I hope that our discussion today has helped illustrate the inherently collaborative and nimble nature of our credit research process here at T. Rowe Price. 

While high yield and investment-grade credit are distinct asset classes with different characteristics and investor bases, Elliot and Mike collaborate extensively to help obtain a fuller picture of the credit environment for energy-and commodities-related. And of course, the work of our equity analyst colleagues will continue to inform our credit views, particularly in light of the cyclical nature of the productivity cycles in energy. Thank you for watching.