Given the importance of the energy sector to the Canadian economy — 6.8% of GDP and 16% of total investment, according to the Energy Council of Canada — it accounts for a surprisingly modest share of the country’s corporate bond market.
According to CIBC, energy-related issuance reached $5.575bn in 2012, or 15.7% of total Canadian dollar corporate non-financial issuance. Of this total, which was up from 13.7% of all issuance in 2011, $3.95bn was accounted for by investment grade issuance, with $1.625bn in the high yield market.
By early September, total issuance in 2013 was $3.985bn, or 14.7% of the total, with the distribution between investment grade and high yield issuance similar to 2012. These numbers, however, refer to issuance in the entire sector, which includes energy-related infrastructure.
Sean Gilbert, managing director of debt capital markets at CIBC World Markets, says that on average, exploration and production (E&P) companies account for between 2% and 5% of total annual issuance.
That is well below the market’s capacity. “On the investment grade side we believe the Canadian dollar market has the capacity to absorb between $4bn and $6bn annually of E&P issuance, and we’re nowhere near that level today,” says Gilbert.
Bankers say that the outlook for issuance in the broader Canadian energy sector is mixed. “In terms of access to capital, I would divide the industry into the E&P or upstream sector on the one hand and the infrastructure or midstream sector on the other,” says Derek Neldner, managing director and head of the Canadian energy group at RBC in Calgary.
“For E&P companies, the capital intensity of the Canadian energy industry has continued to increase. At the same time, with commodity prices under pressure and the sector out of favour in the capital markets, for many companies access to the debt and equity markets has been challenged.” The result, he says, is that much of the sector has been reliant either on cashflow, bank debt, or asset sales to underpin its financing requirement.
Randy Ollenberger, managing director and head of the oil and gas research group at BMO Capital Markets, agrees that while capex plans at the largest companies remain extensive, little of this is likely to feed through into capital market issuance. “Five years ago there were many more oil sands projects in the pipeline than there are today,” he says. “Today, the investment plans are much more concentrated among the larger companies such as Suncor and Imperial Oil. These companies are still spending tremendous amounts of money, and oil sands probably represents about $25bn a year of capex for each of the next five years. But this will largely be funded by cashflow, with a small amount of incremental debt and not much in the way of equity.”
Living within their means
That may reflect the inherent conservatism of large sections of the Canadian corporate sector. “In the large cap sector the mantra is of companies living within their means,” says CIBC’s Gilbert. “The funding requirements of these companies will be relatively modest and focus chiefly on refinancings. While they won’t look to shrink their aggregate debt, these companies are wary of increasing it, especially in the gas-weighted sector.”
There is certainly little sign of any immediate refinancing pressures in the Canadian energy sector. According to DBRS: “Liquidity, defined as cash balances and available credit facilities, decreased slightly but still remained well above historical norms for the sector in Q1 2013.” Cash balances, says the DBRS report, reached $200bn in the first quarter of this year.
The DBRS analysis adds that “on average, maturities are well spread out, with no concentration of maturing debt.” With more than 45% of debt maturities due in 2018 and beyond, says DBRS, “refinancing risk remains low across the sector.”
DBRS advises, however, that “for some smaller operators, there is slightly greater refinancing risk, as available liquidity is often in the form of credit facilities as opposed to cash.”
CIBC’s Gilbert agrees that relative external funding requirements may be higher in the non-investment grade sector than they are among the largest companies. “On the high yield side, we may see companies increase budgets, because the smaller you are, the more important it is to maintain and grow production levels,” he says.
Gilbert and other bankers say, however, that a more vibrant area of the capital market may be bond issuance from companies in the infrastructure or so-called midstream sector of the energy industry. “There is a continual shortage of transportation pipelines and rising demand for gas treatment, processing and gathering companies,” says Gilbert. “The midstream sector has emerged as a source of about $3bn of supply a year, which is double the size of the market five years ago.”
At RBC, Neldner agrees. “There are a lot of growth projects underway in the energy infrastructure sector calling for a significant amount of funding. The energy infrastructure organizations have very strong access to financing, which is the polar opposite to what we’re seeing in the E&P sector,” he says.
Rising issuance in the energy infrastructure sector, says Gilbert, has dovetailed with growing demand among local institutional investors, especially at the long end of the yield curve, where infrastructure requirements are highest. The most extreme example was the issue in July 2012 of a $100m 100 year transaction by Enbridge Pipelines, which was the first 100 year issue from a Canadian borrower for 15 years. The ultra-long Enbridge deal, led by BMO Nesbitt Burns, was bought by a single insurance company, and priced at a coupon of 4.1%, or 185bp over the Canadian government curve. The company said at the time that this represented no more than a modest premium over what it would have paid for a 30 year bond.
“The Canadian market is evolving towards longer dated and larger deals,” says Gilbert, who points to two recent issues in the energy infrastructure sector as evidence of the trend. The first of these is the $700m two-tranche issue launched in June by the Calgary-based pipeline and gas distribution utility holding company, Enbridge Inc, which is undertaking a $32bn five year capex programme. The Enbridge issue, led by CIBC, HSBC and RBC, was split into a $450m 10 year tranche priced at 150.4bp over Canadian government bonds, and a $250m re-opening of an existing 2042 bond, at a spread of 178bp. That, says Gilbert, made the Endbridge issue a landmark transaction, given that it was the company’s largest issue to date.
Another notable recent transaction, says Gilbert, was the $200m 2043 issue for the Calgary-based transportation and midstream service provider, Pembina Pipeline Corp, which was its first 30 year transaction. Led by CIBC and National Bank, the Pembina issue was increased from an originally planned $150m, with momentum driven by a few large reverse enquiries.
This strong demand, says Gilbert, allowed the triple-B rated Pembina to achieve its objective of pricing at a sub-5% coupon, with the issue priced at 4.75%, which equated to a spread over the government benchmark of 235bp. “The fact that Pembina’s 30 year transaction was so well received is a strong indication of how comfortable the investor base has become with the midstream sector,” says Gilbert.
That investor base, says Neldner at RBC, is attracted by what he describes as an almost perfect set of circumstances. “Energy infrastructure companies are very appealing to investors because they offer a unique combination of defensive characteristics, strong organic growth prospects, and an attractive yield,” he says.
In the upstream sector, investor demand also remains strong. Limited supply, however, is opening up opportunities for top quality international issuers to access the Canadian investor base. “Because E&P issuance by Canadian companies has been relatively quiet, the secondary market for this sector is fairly tightly bid,” says Gilbert. “That has led companies like BP to look at the market which can absorb issues of $500m or more at very competitive levels.”
Analysts say that while many of the top companies in the Canadian energy sector may continue to enjoy ample access to bank debt and to liquidity in the bond market, the equity market has been much less accommodating, for a number of reasons. “Concerns over global economic growth, the outlook for China and emerging markets, and implications for commodity prices have led investors to underweight the energy sector in general,” says Neldner at RBC in Calgary. “Against this cautious background for energy globally, equity investors in the US and Europe have tended to put their capital to work in their home market rather than in Canada.”
There are also a number of more specific factors that have made equity investors wary of the Canadian E&P sector. Foremost among these, says Ollenberger at BMO, has been the competition for investors’ attention that has been created by the shale oil boom in the US. This recently led the International Energy Agency (IEA) to forecast that the US will overtake Saudi Arabia as the world’s leading oil producer. “The growth of the shale oil sector has led to a lot of new equity issuance in the US which has satisfied the appetite of US investors and displaced much of their traditional demand for Canadian equity,” says Ollenberger. “There is also a perception among international investors that Canada is a higher cost jurisdiction than the US, when in fact the supply costs for oil sands projects are generally competitive with shale oil.”
International equity investors may, however, be missing a trick. As Neldner at RBC in Calgary says, perhaps the strongest indication that the Canadian energy sector represents attractive value was the recent purchase by Warren Buffett of 17.8m shares in Canada’s largest oil and gas company, Suncor Energy. “Buffett has obviously done very well as a value investor and he clearly believes certain Canadian energy companies are now trading at too much of a discount,” says Neldner.
“He is right to regard the sector as undervalued,” Neldner adds. “We have had a strong energy sector for multiple decades, which has always been regarded as a global operational and technological leader and has proved itself to be entrepreneurial and adaptable.”
Public equity investors’ loss may be private investors’ gain, says Neldner. In the continued absence of much support from the public equity market, he says, a number of Canadian energy companies have been exploring alternative funding sources. “Companies can only take on so much debt,” he says. “With public equity markets challenged we will see more companies trying to raise additional capital through asset sales or by bringing in joint venture partners or private equity investors.”