Credit opportunities within the energy sector: a relative value analysis

The second wave of Covid-19 will inevitably translate into slow economic activity, which will disrupt demand and prices for crude oil and fuel once again. Companies that are more exposed to commodities' market prices will experience severe financial repercussions. In contrast, renewable electricity companies will be more insulated to market price swings.

The market is, therefore, envisioning a renewable era ahead of the pandemic. The transition to green, however,  will be gradual, meaning that for the next few years, we will still need to rely on the traditional energy sector.

A considerable part of investments will need to continue to flow to sustain existing levels of energy supply in order to ensure that there will not be disruptions in economic activity. Thus, we will most likely see governments supporting struggling energy companies through stimulus packages. That's why, we believe that although the energy sector is suffering, government-owned energy companies are better positioned to take advantage of an economic recovery as well as state support.

In this article, we compare various energy companies and analyze their creditworthiness to understand which bonds are the best in terms of risk-reward.

In the table below, we compare 15 energy companies. In terms of leverage, we find Russian energy companies to be in better shape than the others—Lukoil and Gazprom, offer some of the lowest debt to EBITDA ratios of the list. Lukoil particularly shines because of its high interest-coverage rate, which highlights the fact that the company can efficiently service its debt. In yield terms, Gazprom US dollar bonds trade richer than Lukoil. Gazprom 2027 notes (XS2196334671) offer 3% in yield, which is around 40bps over the Lukoil notes maturing in 2026 (XS1514045886). The extra yield offered by Gazprom's bonds doesn't come risk-free. Indeed the latest operating margins of the state-owned company are negative, meaning that it has troubles turning revenues into profits. As the ruble weakness persist, larger losses can be triggered on dollar and euro-denominated debt. Thus, Lukoil is in slightly better positioned than Gazprom to absorb these losses with a higher operating margin. It is important to note, however, that Gazprom is government-owned while Lukoil is a private company. Because of the unique circumstances caused by the coronavirus pandemic, Gazprom is therefore in a better position to take advantage of government support.

Looking at the highest paying energy bonds of the lot, we find that Petrobras and Ecopetrol offer over 4% in yield for maturities above seven years. The Colombian state-owned Ecopetrol, which is also one of the 25 largest petroleum companies in the world, looks to be the more solvent compared to Petrobras besides paying the highest yield. According to Bloomberg data, Ecopetrol has a high interest-coverage ratio and operating margins, while leverage is in line with the industry's average.  It may be possible that the government will seek to sell a stake in the company to raise funds for the National Treasury as Colombia's fiscal deficit widens due to the Covid-19 pandemic. Ecopetrol with maturity 2030 (US279158AN94) offers a competitive yield of 4.2%.

The bonds that pay the most attractive yield of all are Pemex’s. The Mexican state-owned petroleum company's survival is tightly linked to the one of the country's. The government heavily relies on the collection of taxes and duties from Pemex, and their burden weigh on the company's cash flow generation. It ultimately translates in a constant need for new debt to maintain adequate liquidity. While the company’s debt has continued to soar over time, regional competitors such as Petrobras and Ecopetrol have managed to reduce it. At this point in time, the company depends on access to the debt market to continue existing operations. If it fails to raise capital, the Mexican government will need to inject liquidity, exposing the country’s government bonds and Pemex’s corporate debt to a rating downgrade.

A global resurgence in Covid-19 cases is now inevitable; thus, we will surely see more disruptions in the energy sector caused by slowing economic activity. Within this context, I believe that Pemex bonds can fall further together with the Mexican government debt and that a new rating downgrade is most likely. Pemex remains an interesting debtor as its euro-denominated 2029 notes (XS1824424706) offer a rich 6.6% which is rare to find. However, we believe that these notes will offer better value at the beginning of next year, once that coronavirus infections are slowing down and that the US election will be long forgotten.