NEW YORK, Jan 22 (Reuters) - A prolonged period of depressed oil prices could put additional pressure on business development companies (BDCs), which specialize in lending to middle market companies and are already feeling the pinch from portfolio yield compression and dividend cuts, market participants told Thomson Reuters LPC.
Oil prices have plunged more than 50 percent since June and are not expected to rebound meaningfully before at least 2016. This scenario will sap cash flows of portfolio companies whose revenues are heavily tied to oil exploration, production and oilfield services and could limit the ability of certain borrowers to service debt.
“The oil price correction will be a much bigger topic for this earnings period,” said Christopher Nolan, senior analyst at MLV & Co who provides BDC coverage. “It will be an active conversation.”
BDCs have about 6.3 percent exposure to the oil and gas sector, on average, for a total of $3.24 billion, according to Wells Fargo Securities. This excludes the $3.26 billion FS Energy and Power Fund (FSEP), a non-traded dedicated energy BDC.
BDC oil and gas exposure, however, ranges from about 0.1 percent to 16.8 percent, again excluding FSEP. The size of energy-related exposure varies widely, as do the types of investments. Some BDCs provide senior loans that sit at the top of the capital structure, while others invest in junior debt or provide equity capital. Likewise the energy subsectors in which portfolio companies operate will determine the level of impact from oil price volatility.
In late November, when OPEC decided not to cut production and oil prices tumbled further, initial concerns that BDC performance would suffer as a result of oil and gas exposure were said to be overblown.
Rather, the consensus among analysts and market participants is that BDCs were largely oversold in the fourth quarter due to a combination of factors and that energy losses were only part of the story.
Analysts said the volatility in BDC shares was primarily a function of declining portfolio yields, dividend coverage challenges and a considerable amount of selling ahead of year end to offset losses for tax purposes.
Oil prices, though, have eroded further this year and analysts are now expecting a sustained period of depressed prices. By mid-January the price of Brent crude oil, the global benchmark, dropped below $50 per barrel, tumbling by more than half since June 2014 when it sold for $115 per barrel.
The fallout for borrowers will depend on how long the price of oil stays low, said one senior banker. U.S. exploration and production companies, especially those that are less well capitalized, will certainly come under pressure, he added.
In a report published last week, PIMCO analysts wrote that “it is unlikely that oil will return to the triple-digit price range over the cyclical (six- to 12-month) horizon.”
Moody’s Investors Service on January 15 said it sees the price of Brent crude lingering around $50/barrel through 2015 and rising to $65/barrel in 2016. Likewise, the rating agency expects the price of West Texas Intermediate (WTI) crude, the U.S. benchmark, to hover at $52/barrel in 2015 and increase to $62/barrel in 2016.
“Lower oil prices will directly reduce cash flow in 2015 for exploration and production (E&P) companies, which will try to offset the shortfall by reducing their capital investments,” wrote Moody‘s. The steep reduction in E&P capital spending will in turn reduce earnings for oilfield services and land drilling companies, the rating agency noted.
On the back of oil price volatility, the term debt of some oil and gas issuers has already traded off significantly over the last three months, according to Thomson Reuters LPC data.
Among names held by BDCs, Energy & Exploration Partners’ $775 million term loan B is bid at 79.12, down 25 percent since October. Templar Energy’s $550 million TLB is bid at 57, representing a 36.7 percent decline over the same period. And Stallion Oilfield Services $375 million term loan dropped 17.5 percent to a 78.75 bid.
This is the type of environment where investors will differentiate between winners and losers in terms of asset and credit quality. Underwriting and portfolio management will also be key factors in BDC performance in 2015, analysts agree.
“A BDC can have high oil and gas exposure, but if the underwriting is correct it will fare better,” said Nolan. (Editing By Michelle Sierra and Lynn Adler)