Asset Management

High-yield investors unearth opportunities in the U.S. energy revolution

Michael Ainge, CFA, Managing Director, Fixed Income Research

November 27, 2013

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The domestic energy industry has undergone a revolution over the last decade. Higher commodity prices spurred the development of new technologies that unlocked vast, unconventional oil and gas reservoirs, dramatically reversing hydrocarbon production trends in North America. Natural gas production has never been higher and oil production has reached levels not seen since 1992.

Unlocking vast reserves of oil and gas, much of it previously trapped under shale beds, has the potential to transform the U.S. economy in the years to come. Just a decade ago, for example, very few could have imagined that liquefied natural gas (LNG) terminals in the U.S. would need to be retrofitted for exporting rather than importing the commodity. The energy revolution has created many opportunities for investment, including for high-yield investors, as many companies directly involved in finding, extracting and moving gas and oil are below investment grade. High-yield bonds issued by oil and gas exploration and production companies and companies focused on building and operating pipelines and infrastructure are just a few vehicles investors use to gain exposure to the shale boom. Insight into the energy boom’s impact on other sectors has also yielded many investment opportunities.

Article Highlights

  • The U.S. energy industry is being transformed as rising commodities’ prices spurred the creation of new technology that has unlocked vast unconventional reservoirs of oil and gas.
  • The changing landscape creates investment opportunities for high-yield investors, including not just the energy industry but other sectors that benefit from more abundant and cheaper resources.
  • Understanding the risks and opportunities of the energy revolution is critical for high-yield investors seeking exposure to the unconventional energy theme in the years to come.

Rising prices, rising production

The domestic energy revolution began in the mid-2000s as natural gas prices soared to record highs (Exhibit 1). The high prices encouraged exploration and production (E&P) companies to invest in hydraulic fracturing technology to produce natural gas and later oil from shale formations. As the development of these reservoirs matured, production rose, resulting in record amounts of natural gas now being produced domestically. The historic production increase drove North American natural gas prices significantly down over the last decade.

Exhibit 1

Exhibit 1

This is a reversal from the early 2000s, when North America was expected to become a major importer of liquefied natural gas (LNG). There has been a burst in energy-related construction, including new infrastructure needed to support the boom, which has also created many new investment opportunities in the energy sector and beyond.

Cheaper, more abundant energy benefits many industries

While the boom in production has many positive implications for the energy sector and the overall U.S economy, increased domestic oil and gas production from shale plays has transformed many related industries such as the pipeline, chemical, utility and transportation industries, further expanding the opportunities for unconventional energy investment opportunities.

Pipelines: The midstream energy sector is spending billions on new pipelines, gathering systems and natural gas processing capability. Pipelines built to gather and transport oil and gas from older, conventional fields aren’t necessarily positioned to carry the new production from shale plays. Pipeline operators are scrambling to meet demand for new infrastructure in regions that historically had not been active drilling areas, such as the Eagle Ford Shale of South Texas, the Marcellus Shale in Pennsylvania and New York, and the Bakken Shale in North Dakota.

Chemicals: The chemicals industry uses natural gas in many of its raw materials (called feedstocks), so it has benefitted from falling prices: The cost competitiveness of domestic chemical companies has improved and the export market has become a major source of profitability. For the first time in decades, North America is the focus of capacity expansions from both existing North American companies and foreign companies looking to enter a market with the expectation of many years of good pricing.

Utilities: The steep decline of natural gas prices since 2008, the abundant supply, and the costs associated with environmental compliance triggered a shift in utilities’ preferred fuel sources. In the summer of 2012, natural gas, for the first time ever, generated nearly as much power as coal. Cheaper, more abundant natural gas has created winners and losers within the Independent Power Producer (the predominantly below investment grade companies that sell power to regulated utilities) sector based on the composition of their generating fleet. Insight into the shifting competitiveness within the IPP sector creates investment opportunities.

Transportation: Rail, barge, and truck companies benefited from the shortage of pipeline capacity in areas such as the Bakken. Ground and marine transport of crude oil has significantly increased, although it remains a small percentage versus pipeline volume. In 2012, these alternative transportation sources carried only about 7% of the domestic hydrocarbon volume, compared with 80% for pipelines. This is, however, the highest percentage that these alternatives have provided. Both truck and rail shipments are the highest they have ever been and barge shipments have matched a high last reached in 1984. From 2011 to 2012, barge shipments increased 118%, rail was up 382% and truck shipments were up 38%, which demonstrates the robust growth rates for alternative transportation sources. Crude oil producers and users started to embrace the flexibility that these alternatives offer them. Pipelines, while cheaper, only transport crude oil along a set route. Rail, barge and truck transport give producers more choice to where they ship and users more alternatives from where they source their oil.

How high-yield investors gain exposure to the boom

Investors seeking to capitalize on the rise of unconventional oil and gas plays have several options for their portfolios. Many of the biggest operators in these new reservoirs are below-investment-grade E&P companies.

Another option investors may consider is midstream energy companies, which build and operate gathering, processing and transportation infrastructure for the energy sector and have helped E&P companies meet their growing infrastructure needs. Many of these companies are master limited partnerships — a tax-advantaged structure in which all excess cash flows are paid as dividends. Because MLP cash flows are generated from fees collected on hydrocarbons passing through their pipelines, investors can participate in the unconventional oil and gas boom while minimizing their exposure to commodity price volatility. Investors may want to consider adding a high-yield component that invests in these structures, such as a high-yield fund, to their portfolio.

The returns for funds with exposure to the below-investment-grade companies that are active in unconventional plays may receive an additional boost from acquisitions. As activity surrounding these reservoirs increased, large integrated oil companies, both foreign and domestic, acquired smaller companies already active in the region, often at a premium. Merger and acquisition activity has also been strong in the midstream MLP space. Our research team expects merger and acquisition activity to continue, and that the fundamental credit quality of the sector will continue to improve.

Risks to consider

The U.S. energy revolution has not occurred without opposition and controversy, including over the extensive use of hydraulic fracturing or “fracking.” Fracking injects large volumes of water, specialty sands and chemicals into wells under high pressure to fracture the reservoir and improve the flow of hydrocarbons. There are concerns about contamination of aquifers with fracking fluids as well as contamination of surface water as fluids are pumped out of a well and stored in ponds for further treatment and/or recycling. More regulatory oversight (on both the state and federal level) over fracking and new wells is the most likely outcome to these concerns. We view outright bans on fracking as highly unlikely due to the economic benefits of the increased drilling.

There is some opposition to exporting LNG and oil. Manufacturers, particularly in the chemical industry, oppose the export of hydrocarbons, particularly natural gas, as the current increase in supply and price decrease has provided a meaningful benefit to the industries’ profitability and competitiveness. While natural gas exports are likely, we believe exporting crude oil is less likely because the U.S. still imports a large portion of its oil and because of political concerns.

Demand and U.S. production expected to continue rising

The discovery of the techniques required to unlock the potential of North American unconventional resources transformed the U.S. energy industry. As the worldwide demand for energy continues to rise, and as the U.S. seeks to reduce its dependency on foreign oil and reduce carbon emissions from coal, demand for increased production from unconventional domestic oil and gas reservoirs is likely to continue rising for years to come. While promising, there are many risks to consider, such as potential for environmental and social issues related to drilling, geopolitical risks and the potential for volatile commodities prices. Investors should consider their risk tolerance carefully before investing in high-yield funds or assets.