The Impact of Climate Urgency on the Energy Sector | Lord Abbett
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Fixed-Income Insights

The IPCC report on climate change may spur investors to deepen their engagement with energy companies on environmental issues.

Read time: 3 minutes

The United Nations (UN) Intergovernmental Panel on Climate Change (IPCC) recently published an assessment that is an emphatic reminder that climate change is among the most urgent of the challenges we are facing. For investors, it underscores the importance of climate-focused investment opportunities. The scale of the response that is necessary to meet the challenge makes it clear that an approach focused on engagement with energy companies is potentially better than a simple exclusion/“no buy” option. We believe an open dialogue with companies that have environmental shortcomings—and practical ways to improve them— is much more productive than refusing to get involved with them. Some of the companies that can do the most to help the environment are the ones who are currently doing the least, so it makes sense to discuss with them possible solutions.

The IPCC report clearly stated that the role of human influence on the climate system is undisputed, and that carbon dioxide is the main driver of climate change. Given that energy companies produce a high level of CO2 emissions, the report serves as an impetus for the public and private sectors to more aggressively engage management teams of companies that are high carbon dioxide and greenhouse gas (GHG) emitters and push them for more rapid emission reductions.

The report provides further data that support our engagement initiatives with management teams in the energy sector and reaffirms our belief that energy companies need to put forth immediate-term plans to reduce Scope 1 – 3 emissions, GHG intensity, methane intensity, and freshwater usage.

The Risks that Could Spur Further Action

We view three primary risk factors within our assessment of the high yield energy sector that could be driven by the IPCC report. These risks include government regulation that may increase an energy company’s cost of capital, reduced investor demand for energy-related bonds that could potentially cause spread widening, and a potentially higher risk premium for energy-related companies that could cause spread widening. Ultimately, all three of these risk factors tie into a potential higher cost of capital for energy companies.

While all the high yield exploration and production (E&P) companies in our portfolios are in the process of reducing emissions, we are hopeful that the report will spur more broad-based, private sector engagement and faster emission reductions from the energy sector.

A Constructive Outlook

We have been constructive on the energy space across credit portfolios. We find that management teams are retaining high levels of capital-spending discipline and balance sheet-friendly behavior, with spending down nearly 40% versus 2017-2019 levels across the industry. Leverage levels have improved materially from their 2020 peak, and at current spot prices, the vast majority of E&P companies have meaningfully positive, free cash flow, providing an accelerant for further credit improvement and a rise back to investment-grade status for many of 2020’s fallen angels. Indeed, our work suggests that short of oil prices falling below $50/barrel, these supportive cash flow dynamics should remain in place.

We highlight the relative underperformance of the high yield energy sector, mapped against the spot price of crude oil in Figure 1. Specifically, note that the difference in spreads between the ICE BofA U.S. High Yield Energy Index and the ICE BofA U.S. High Yield Constrained Index is back to levels from about four months ago. However, oil prices are reasonably higher since then; the prospect of greater future profitability may compress spreads over time, suggesting an opportunity.

 

Figure 1. The Potential Opportunity in the High Yield Energy Sector
The spread differential between the high yield energy sector and the high yield market mapped against the spot price of crude oil from February 12, 2021-August 12, 2021

Source: Bloomberg Index Services Limited and ICE Data Indices. Data as of 08/12/2021. Spot crude oil price derived from West Texas Intermediate (WTI), which is a grade of crude oil and refers to the price of the New York Mercantile Exchange WTI Crude Oil futures contract. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

A Final Thought

With the energy sector at the crossroads of environmental, social, and governance (ESG) concerns, we remain active in efforts to engage companies across the industry on their plans to improve their environmental profile and the challenges they face, as well as how developments are reflected in valuations. We have had success with certain E&P companies, both in encouraging those companies that have had no or limited ESG targets to develop them and in pushing companies that have goals to enhance them or move toward them more aggressively. As various layers of the U.S. government respond to the challenge of climate change, and companies adjust their operations, our role as ESG-focused investors is to reward approaches that are thoughtful and appropriate, while pushing back against those that seem ineffective.

The degree of reporting, goals, and achievements related to climate change vary across issuers (particularly by company size). But the industry’s awareness has never been greater; many of the participants we engage with have gradually reduced Scope 1-3 emissions, as carbon capture, cleaner power sources, and operational improvements all play a part in addressing the industry’s current—and future—environmental impact. 

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

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Equity Investing Risks

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The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price.

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This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described here.

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Glossary Definitions

Environmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially-conscious investors use to screen potential investments.

Fallen angels refers to bonds that have been downgraded from investment-grade to speculative-grade status.

Free cash flow is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets. 

The risk premium is the rate of return on an investment over and above the risk-free or guaranteed rate of return, 

Under greenhouse gas protocols defined by the World Resources Institute, Scope 1 emissions are direct emissions from company-owned and controlled resources. Scope 2 emissions are indirect emissions from the generation of purchased energy from a utility provider. Scope 3 emissions are all indirect emissions (not included in Scope 2) that occur in the value chain of the reporting company, including both upstream and downstream emissions.

The ICE BofA U.S. High Yield Constrained Index tracks the performance of U.S. dollar-denominated, below-investment-grade, corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade rating (based on an average of Moody’s, S&P, and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed-coupon schedule, and a minimum amount outstanding of $250 million.

The ICE BofA U.S. High Yield Energy Index is a subset of the ICE BofA U.S. High Yield Index and tracks the performance of the U.S. dollar-denominated, below-investment-grade, corporate debt publicly issued by energy companies in the U.S. domestic market.  

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.

The ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar-denominated, below-investment-grade, corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade rating (based on an average of Moody’s, S&P, and Fitch), at least 18 months to final maturity at the time of issuance, at least a one-year remaining term to final maturity as of the rebalancing date, a fixed-coupon schedule, and a minimum amount outstanding of $100 million.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

This material is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved.  

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