State of Credit markets now and in the future?

US high yield credit markets are Russia's worst enemy (Originally Posted: 03/23/2014)

A lot has been discussed about the Crimea/Russia situation, and many of the topics focus on how Western Europe is very much limited in what they can do to prevent Russian aggression. As long as no NATO country is attacked, Russia’s incursions into Ukraine and other non-NATO regions fall into the territory of ambiguous response. Because of the deeper economic ties between the region - with Russia shipping natural gas/oil to Europe, and Europe sending manufactured goods to Russia - any sanctions would hurt Europe as well. And dramatically higher power prices in democratic Europe would hurt the politicians who imposed those sanctions….where as rising consumer goods prices in Russia won’t matter to Putin, who isn’t subject to elections or a critical press. He knows this, and is in a good situation as a result.

I won’t dive too deeply into my views on Western Europe – I generally think the US will continue to dominate politics and global affairs, with Western Europe continuing to largely rely on the US for military support and implicit guidance in foreign affairs, with the occasional complaining about unilateral US policy but largely falling in line with Uncle Sam’s wishes. The Ukraine situation, in my opinion, was just another example of Europe failing at establishing itself as a leader in its own region and being unable to counteract the Russians at one of the most critical post-Cold War era junctures. It was pathetic.

However, Russia is just biding its time. The Western world, led by the US, will prevent Russia from remaining a belligerent. And the US will lead, but not with our superior military or technology. And it won't be with our diplomacy. Russia’s leverage over Europe and the Western world will slowly dwindle away because of capitalism, and US high yield credit markets.

I won't bother getting into the history of the US energy sector, fracking, Russia's energy dominance in the region, and all that - its been researched and discussed by many people better informed than me. Rather, I will focus on qualitative aspects of the US energy industry, the role the credit markets play in them, and how a lack of Russian focus on reinvestment will eventually allow the Western world to outproduce Russia. I will also mention a few companies which exemplify the imperative role of high yield credit.

Russian corporate owners have little incentive to invest, so they extract

The ability for the Western world to access to high yield credit markets has dramatically increased technological innovation, and the energy sector is no different given the recent advent of fracking, small scale E&P, regional oilfield services, and pipeline construction which all utilized significant access to high yield credit markets.

This evolution of technology and production has been lacking in Russia, where the majority of corporate behavior can be characterized as value extraction (or in some rare cases, JVs with Western companies). Oligarchs who control the largest raw material deposits in the former USSR are not reinvesting capital or reinvesting cash flow to improve manufacturing processes and diversify their operations. Efficiency and competitiveness are not issues that they are concerned with - rather, they treat Russia's oil and gas industries as cash cows in decline. Further, creditors certainly aren’t lending to politically connected oligarchs in a Russian economy where credit markets, bankruptcy codes, and general rule of law can be easily bent by a government focused on nationalist interests.

This is not to blame the oligarchs for their own actions – they benefit very little from reinvesting cash flow into their corporations. At any given moment, President Putin could become angry with them and cease control of their operations. Given this, cash flow from operations is typically put into foreign bank accounts and foreign real estate, as opposed to being reinvested in Russia. Russian equity owners feel content on supplying Europe with ~35% of its energy right now, then in turn putting their excess cash flows into savings accounts rather than reinvesting.

US energy can (slowly) become Europe’s energy savior

The US is dramatically improving its ability to extract oil and natural gas, and it has the ability to become the world’s largest energy producer. I won’t dive into this aspect – there is significant literature around the growth of fracking, horizontal drilling, and related technologies.

Rather, I’ll focus on the ability for these companies to raise debt capital. US credit markets, bankruptcy laws, and legal procedure give creditors comfort in making risky investments with the promise of collateral. This has been a driving force for the US E&P sector and the recent explosion in investment in the sector.

Case in point: LNG

There are many examples of how US lending and credit markets allows for entrepreneurial companies to take risks which result in superior technology and a general outward shift of domestic productivity.

One recent company in the HY market is Cheniere Energy (ticker LNG). The company had $3.0B in debt outstanding in 2011, versus a market cap of under $1.5B – meaning lenders were taking a bet, and the equity owners were willing to use that capital to make an investment on an idea they had, as opposed to simply extracting value. LNG largely used high yield debt to finance its liquefied natural gas terminals, which in conjunction with its exploration segment, may become a massive energy exporter. Since 2011, the company has issued over $5.0B in additional debt, bringing its total outstanding to $6.6B. Over that time, its market cap has risen from $1.1B to $12.4B. Between FY12 and FY13, LNG invested over $4.0B in capex. Now, it stands ready to become a global leader in LNG exports.

Of course, LGN is just a small subsector in a vast, growing, and productive US energy sector. Even small companies are worth mentioning – take a look at QR Energy (ticker QRE) – the company had minimal cash flow from operations, yet invested close to $1.0B using debt financing in 2011, and has seen its enterprise value increase 300% between FY10 and FY13 ($800mm to over $2.0B). Countless other E&P companies have benefitted from access to credit, which has allowed them to engage in exploration, and incentive them to take risk.

Would a company in Russia be able to issue significant amounts of high yield debt and then grow into the structure? No. The ability for the government to dominate Russia’s largest sector, energy, scares creditors from helping smaller companies from starting up. A lack of competition in the sector, combined with uncertain property rights, and ownership that is less entrepreneurial than extraction oriented, would certainly never allow a company like LNG to even exist, let alone invest $4.0B in capex using largely credit financing in return for a future pay-off. Rather, any incremental cash flow would largely be sent flowing a Swiss bank account, rather than innovating and improving process efficiency.

US credit markets create ecosystems

In the energy sector, the oil majors like Exxon and BP have dominated, but high yield E&P companies have raised capital through both credit and equity markets in order to invest, explore, and use new technologies. Hand in hand, oilfield services companies such as Nabors, Basic Energy Services, UTI Energy, and countless other smaller firms without steady access to equity capital used credit markets to grow. These companies came to take share away from established companies such as Halliburton and Baker Hughes, and evolved to provide the specific types of work needed for an evolving E&P industry.

Companies such as US Silica and other small chemical producers evolved through the capital markets in order to provide supplies to fracking service companies, which in turn were employed by high yield E&P companies. Entrepreneurial owners were willing to mortgage their equity stakes in these companies in order to raise capital to fund true investment in this sector.

Energy pipeline companies and storage facilities were financed using debt. Not all of these have been successes. A pipeline located in an even where breakeven costs ended up escalating likely went bankrupt or become stressed, and equity value may have been wiped out – but in the process, even the failures because data points for future innovators. And at least the people behind them tried – and they tried because they had ability to access high yield credit, and they believed in investing versus extracting.

The takeaway is that credit markets were used to finance all aspects of the energy ecosystem - from the exploration, to the services, to the transportation. Owners were able to invest in LONG-TERM innovation using loans and bonds, which over time led to the development of ancillary subsectors. The ability to borrow money and time it against future cash flows is something likely frowned upon by Russian oligarchs, who likely view their oil and gas resources as a dwindling piggybank.

Slowly drowning the Russian bear with Uncle Sam’s natural gas

The US will be able to continue to innovate in the energy sector, and will export its innovation through its companies as they invest around the world. Once creditors become comfortable with the cash flow profiles of E&P companies in their domestic regions, surely replicating the success of fracturing/horizontal drilling technology in order regions will be next on the list.

Further, once regulations ease, the capital deployment focused on liquefied natural gas, led by LNG currently but also a point of focus for many other companies in the sector, will allow the US to become a major exporter of natural gas.

The arbitrage between European gas prices and US gas prices fluctuates, but its largely thought that it exceeds the costs of transportation at current levels. However, the arbitrage will become less relevant as continued investment focuses on reducing those transportation costs.

Russia currently supplies 30%-35% of Europe’s crude oil and 35%-40% of Europe’s natural gas. This is around 300mm tons of oil equivalent a year. Most notably, Russian natural gas is over 30% of Germany’s total usage and close to 50% of Poland. Its about 100% for Estonia, Latvia, Luthiania, and Slovakia. The great bear has a mighty bat indeed.

But it’s a bat that will become less relevant if the US becomes a major exporter of LNG – and this has been discussed as much in the press – its expected that less than 100mm tons per year of capacity will developed in the next decade, and little of that will help Russia’s closest neighbors.

But what hasn’t been discussed is how the majority of US innovation and development in its E&P sector was driven by access to high yield credit markets. 10 years ago, no one would have thought US was on its way to energy dependence. No one can say that in 10 years from now, the US will not be Europe’s largest supplier of natural gas…or at the least, we’ve helped develop pipeline infrastructure from Africa, the North Sea, or offshore. All these things are possible, because the US credit market allows innovators to take risk and grow rapidly when there is true opportunity.

Meanwhile, the extractive Russian economy will eventually see a decline in its natural gas reserves, will see an uptick in exploration costs, will see a gradual decline in productivity…and over time, an entire industry will submerge due to a lack of investment. Meanwhile, the bond traders and credit research analysts in the US can pat themselves on the back, because they helped Uncle Sam win again.