The global bond market is playing a critically important role in financing the transition to a more sustainable economy. Within the corporate debt market, instruments such as social and sustainability-linked bonds are being used by companies to transform their business operations to be more sustainable and prepare for the shift to a low-carbon economy.
In the high-yield debt market, growth prospects are limited for the oil and gas (O&G) sector, fated as it is by fundamental secular and regulatory challenges. These challenges have been laid bare by the landmark activist shareholder victories against Exxon, Chevron and Shell in recent weeks.
Greater opportunities instead lie in the climate-aware investing movement, which is causing investors to look at “fossil fuel free” and to find growth in the solutions that are helping to create a lower carbon economy. Many sectors within high yield are primed to benefit from this transition. For example, innovations in broadband telecommunications, technology and healthcare are providing tailwinds for companies in these sectors. In addition, certain industrial companies and automotive suppliers will benefit from the necessary infrastructure improvements and components required to support the electrification of the global transportation fleet.
Fundamental risks of O&G investing are pushing investors to alternatives
Growing fundamental concerns are driving investors across the globe to seek alternatives outside of the traditional energy sector. The energy sector has consistently experienced high default rates and low returns compared to the overall high-yield asset class.
According to Bank of America Merrill Lynch research, in the last 15 years, the default rate in the energy sector has averaged 7% while the rest of the high-yield index has only seen an average of 3.9%. This is due to the typical high debt loads, which have been particularly acute for oil and gas firms given low return on capital, heavy capital requirements, depleting asset bases and growing regulatory pressures.
Investors are taking notice of these fundamental risks and are increasingly avoiding traditional energy in their portfolios. Climate-aware investing provides them with the prospect of higher returns with lower volatility.
External risks pose an even greater concern for investors in O&G
The fundamental risks facing the oil and gas sector, described above, are causing a weakening demand curve, which is arguably the greatest concern for fixed income investors.
It has been estimated that about 50 to 70%1 of the U.S. and 35%2 of the world’s oil production is consumed by the transportation sector. In Western and developed markets globally, regulatory and consumer sentiment is driving a major shift from internal combustion engine (ICE) vehicles to electric vehicles (EVs) as soon as 2030, severely reducing the demand for oil. Bolstering this shift is consumer and political desire for solutions to help combat climate change and modernize infrastructure. As such, the lower demand will put even greater pressure on returns on capital and it will become more and more difficult to service the debt.
On the other hand, natural gas currently powers much of the developed world’s electric power grid. It is widely considered as a “transition fuel” as utilities move away from dirtier forms of energy such as coal to more renewable energy sources such as wind and solar. Given that natural gas is playing the role of a stopgap between a carbon-intensive economy to one that is carbon-free, it has a longer lifespan than oil, but it faces additional regulatory and environmental issues. For instance, environmental regulations are likely to be imposed on fracking, a large way that natural gas is extracted, due to its environmental impacts that include ground and surface water pollution and biodiversity loss from the destruction of natural habitats along with greenhouse gas emissions from methane that is released during the extraction process.
Opportunities for investors — invest in growth sectors that will be a part of the transition
Given the heavy fundamental, regulatory and environmental risks of investing in traditional energy, investors are looking for better alternatives for returns. But what is to replace a sector that currently makes up 14% of the ICE BofA Merrill Lynch U.S. High Yield BB-B (Constrained 2%) Index?
At Impax we use our “Sustainability Lens” to help signpost those sectors that are potentially attractive areas for investment. This allows us to steer away from companies with fragile business models (like within O&G) that may be undermined as the transition to a more sustainable economy accelerates.
With the move to electric vehicles, there is an anticipated expansion of the electric utility grid to fill the white space that oil and gas will leave behind. This will offer areas of growth along the supply chain to support the development, production and convenience of electric vehicles.
In the high-yield market, prime examples of companies that have strong participation in electrification include transmission, axle, and friction component manufacturers. Along with the electrification movement, there are opportunities across infrastructure improvements in high yield. These include companies innovating in the broadband and telecommunication sectors as technology becomes more widespread in demand and reach across the globe.
Between the fundamental and external risks and the great growth opportunities outside of traditional energy, it makes sense to shift client capital to companies disrupting markets and supporting the evolution away from a dwindling sector. High yield as an asset class presents an exceptional opportunity to invest in exciting growth areas that are helping to support the transition to a cleaner and more sustainable economy.
1 U.S. Energy Information Administration, “Oil and Petroleum Products Explained,” May 10, 2021.
2 Statistica.com, “Distribution of Oil Demand in the OECD in 2019, by Sector,” last accessed June 22, 2021.
The ICE BofA Merrill Lynch U.S. High Yield BB-B (Constrained 2%) Index tracks the performance of BB‑ and B‑rated high yield bonds. The Index contains all securities in the BofA Merrill Lynch US High Yield Index but caps issuer exposure at two percent. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed two percent.