Falling oil prices have contributed to market volatility and have materially impacted the value and credit profile of oil and gas companies worldwide. However, where there are losers, there are also winners
By now we are all aware and accustomed to the fact that oil prices have collapsed over the last few years. From a peak level of around US$110 per barrel, crude oil prices have fallen by over 70% since mid-2014 and are currently sitting at around US$30 per barrel. This significant turnaround in oil prices is depicted in the figure below.
While oil prices are hovering around decade lows, oil production levels have not yet adjusted to this new oil environment in a way you would rationally expect. According to global consultancy Wood Mackenzie, only 0.1% of the world's oil production has been halted due to the collapse in crude oil prices, suggesting the recovery will be slower than originally expected. At prices of US$US35 a barrel, close to current levels, some 3.4m barrels of oil a day cost more to produce than the revenues received from sales according to the consultancy. But fewer than 100,000 barrels a day (b/d) of production has been shut so far in this downturn as producers hang on in the hope prices will rise again.
This means we expect oil prices will remain lower for longer as production levels will take time to adjust (reduce) in response to a falling oil price.
While oil and gas producers are facing cashflow pressures in the current environment and their balance sheets are under stress, there are a number of sectors and companies which are expected to benefit from continued low oil prices, which we outline below.
The beneficiaries of low oil prices
While there are many sections of the economy which are hopeful for a rebound in oil prices, companies where fuel costs make up a significant proportion of the cost base are experiencing a strong growth in earnings in a low oil environment.
The airline sector has been a clear beneficiary of the fall in oil prices in recent years. Oil prices are currently at decade lows which are expected to continue into 2016. The financial performance of the domestic airlines, Qantas and Virgin, will continue to benefit from lower fuel costs.
We expect Qantas to deliver record profitability in 2016 and it is likely that Moody’s will follow S&P’s suit and upgrade Qantas’ credit rating to investment grade in 2016. Virgin recently announced a significant 32% uplift in second quarter earnings and is on track for a profitable full year result.
In a continued low oil price environment, exposure to the airline sector is a sound investment given so much of their underlying profitability is determined by fuel costs and we believe that Qantas and Virgin should continue to perform well on this thesis. In addition, companies exposed to the aviation sector, such as the FIIG originated Ansett Aviation Training and Sydney Airport, will also benefit from the improving financial performance from the domestic airlines.
While Qantas is on the verge of being rated investment grade by both Moody’s and S&P, the Virgin bond has a weaker credit rating of B-/B3 and is in USD, so also subject to currency risk. The difference in risk profile and credit rating is also reflected in the relative pricing of the bonds. The Virgin 2019 US dollar bond is currently indicatively offered at a yield to maturity of 8.0% in US dollars while the Qantas AUD lines are yielding between 4.3%-4.8%.
In high yield space, we believe Virgin has the potential to be a solid performing credit and now may be a good opportunity for existing Qantas holders to take profit and switch into the higher yielding Virgin bond. While Virgin’s credit rating is weak we expect that the rating will be uplifted over time if the company can continue to grow earnings and reduce its current high leverage position. We also take some comfort that Virgin is majority owned by four major airline shareholders, including state owned Singapore Airlines which was recently reported to have been considering increasing its shareholding in Virgin.
The low oil price environment is also driving increased traffic growth, which is of course a positive story for bonds in the transportation sector. To think that petrol prices could again fall below $1/litre in Australia was once considered a remote possibility, but has happened in parts of the country. Our preferred bond in the transportation space is Transurban’s Transport Queensland (TQ) bonds (formerly Sun Group) which are secured bonds issued against the Brisbane tollroad network partially owned by Transurban. TQ’s floating rate 2024 bond is currently offered at an indicative yield to maturity of 4.3%.
SCT Logistics’ earnings are also expected to benefit from lower fuel costs, being a rail freight carrier. While it may face increased competition from road based freight given the low fuel price, it still retains a significant cost advantage over road on its key East-West route. SCT currently looks like good value at an indicative yield to maturity of 7.1%.
Lower fuel costs will mitigate pressures on mining companies, such as Fortescue and Newcrest, who will benefit from lower fuel costs at a time when their earnings and margins have been significantly hurt by the sharp deterioration in metals and bulk commodities prices. However, the lower fuel costs will only partially offset weak prices for base metals, iron ore and coal. The Fortescue 2019 USD bond is currently indicatively offered at 13.5% while yields on the Newcrest USD lines are currently between 6.1% for the 2021 bond up to 7.7% for the very long dated 2041 bond.
Please contact your FIIG representative for further information on any of the bonds listed above. All of the bonds listed above are available to wholesale investors only with the exception of Qantas. Yields quoted are current as at 9 February and subject to change.