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Why lower rates mean cheaper financing for some energy companies

Ingrid Pan, CFA

Corporate credit yields indicate the rate companies can borrow money at

“Corporate credit yields” is a general term for the rate companies can issue debt (that is, borrow money) at. Higher corporate credit yields mean more expensive borrowing rates for companies. So higher yields are generally negative for companies—especially those with high funding needs, which include many upstream energy producers. These needs might include expensive capital expenditure (spending and investment) programs, acquisitions, and refinancing of debt coming due. Inversely, lower yields benefit companies, as they result in lower borrowing costs.

Yields trended lower over the past few weeks

Since September, the yield on the BofA Merrill Lynch High Yield Index, the benchmark corporate credit index for non–investment-grade companies (also known as “high yield companies”) decreased from 6.47% on September 30 to 5.95% currently. This resulted in a positive for high yield companies needing debt funding. For further Market Realist discussion about rates, see Realist Real Estate Roundup: Government re-opens and bonds rally.

For much of 2Q13, rates had been climbing rapidly, as the market worried about the Fed Reserve curtailing stimulus measures. At its lowest point, the BofAML High Yield Index reached ~5.25% (early May) but then quickly rose to ~7.00% (late June). During 3Q13, it seemed that the yield on the BofAML High Yield Index began to stabilize generally between 6.00% and 6.50%. Recently, rates have further decreased, as the possibility of Fed tapering seems farther on the horizon.

The BofA Merrill Lynch High Yield Master Index is used as a gauge for where rates for high yield companies are trading

“High yield” is a term used to classify companies with below a BBB rating from rating agencies such as Standard and Poor’s or Moody’s, so high yield companies are generally companies with worse credit quality (which could be due to a number of factors, such as size, leverage, or diversification). You can monitor general corporate credit yields through an index such as the BofA Merrill Lynch Index, which aggregates data from many corporate bonds.

Upstream independent energy companies often spend more than internally generated cash flow, and therefore must look to capital markets to raise funds

Investors should consider monitoring where corporate yields are, as a material move upward in borrowing rates is a negative for companies, as we’ve seen in some periods this year. This is especially true for companies that will need to raise money in the debt market and may be forced to do so at higher rates if yields move upward.

Companies with planned capital spending above cash flow, for instance, will need to source the cash shortfall somewhere—and one option would be to issue bonds in the debt capital markets. Other companies that might need to access the debt markets include companies that are planning to make an acquisition, or companies with bond maturities coming due that need to be refinanced (and likely not enough cash on the balance sheet to simply pay the bond off). Many upstream independent energy companies spend more than internally generated cash flow—especially those in high growth mode with significant expansion and development plans.

Companies whose capex is likely to exceed internally generated cash flow (as determined by consensus estimates of EBITDA and stated capex guidance) include Oasis Petroleum (OAS), Laredo Petroleum (LPI), Chesapeake Energy (CHK), and SandRidge Energy (SD).

The decrease in yield over the past few weeks has been a short-term positive

However, rates spiked sharply earlier this year, in mid-July, and this is a medium-term negative for high yield companies—especially those needing to raise debt funding. Given the possibility of sudden rate movements, as we saw earlier this year, this is a factor that investors may wish to monitor—especially if they expect a company will need access to the debt market in the near future. Note that many high yield energy companies are part of the SPDR S&P Oil & Gas Exploration & Production ETF (XOP).

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