The dramatic oil price plunge last week could lead to a swathe of energy companies defaulting, providing investors with attractive entry points in renewable energy companies caught up in the sector mark-down, said investment commentators

Mark Benbow, investment manager, fixed income at Kames Capital, told ESG Clarity‘s sister title Expert Investor that there may be a “big default cycle coming” in the energy space later this year or early next year, “because of the very dramatic price action that happened with oil”.

Brent oil has entered into bear market territory, declining by 13.6% during the week commencing 28 February due to coronavirus concerns, according to Refinitiv.

The sell-off intensified on 9 March, causing brent oil to drop by 24.1%, its largest one-day drop since 1991, after Opec+ failed to achieve cuts in oil production.

Tajinder Dhillon, senior research analyst at Refinitiv, wrote in an article that oil majors, including ExxonMobil, Chevron, BP, Eni, and Total, have all seen downgrades.

When looking at the energy debt of the US high yield index (BAML US High Yield Index) it appears to be concentrated towards lower rated bonds; particularly in BB3, B1, CCC1, and CCC3 buckets, Dhillon noted.

As a result, Kames’ Benbow said the oversupply of oil could trigger a downward spiral in oil prices.

He suggested that, if oil prices are cut by half, oil companies would react by doubling their production to balance out their tumbling revenues.

“That obviously floods the market with even more supply, which pushes the oil price down even further.

“So, it becomes this kind of self-fulfilling prophecy of downward-spiralling oil prices, unless you can get some sort of central agreement with Opec, which is obviously broken down,” he explained.

While oil companies are in a very tough position, renewable energy companies are equally affected by collapsing oil prices, Benbow remarked, as their revenue base is reliant on the same underlying commodity price.

The situation has become so dramatic that even short-dated bonds, which tend to be less volatile, have been selling off in energy, he added.

Impacts on the low-carbon transition

However, some believe that a shake-up in the energy sector could benefit renewable energy companies.

Although low oil prices could also have negative effects for the energy transition in the short term, others argued, as it could hurt demand for renewable energy.

Peter Schwab, high yield portfolio manager at Impax Asset Management, explained that low oil prices may stimulate oil demand in the short term and could put modest pressure on bonds issued by renewable energy companies.

However, he said, in the longer term, “alternative forms of renewable and clean energy will be more competitive than fossil fuels and ultimately displace them”, as the demand for fossil fuels will be too low to generate reasonable returns.

In order to provide investment opportunities, Schwab said, traditional fossil fuel energy companies would need to undergo “material changes in their business model” by allocating profits into clean energy production.

But Impax sees “very few traditional energy companies doing this with any real conviction and commitment now”, which is why the firm focuses on companies offering energy efficiency products.

Energy transition

Kingsmill Bond, energy strategist at non-profit think tank Carbon Tracker, argued that investors should use the current shake-up as a value opportunity to build strong positions in renewable energy.

“Investors should resist the temptation to go back into the fossil fuel sector,” given that oil and renewable energy will see opposite structural demand.

Bond said “renewable energy supply is on an exponential growth curve”, and that growth “will come roaring back”, due to the sector’s falling costs and rising demand.

The oil sector, however, is facing an array of challenges, he added.

Profitability “has been propped by a cartel whose existence is threatened by the structural shift, and the sector now faces a future of massive overcapacity, rising taxation and falling demand”.

“There will be a shake-up in the sector now and the stronger players will emerge more resilient,” he said.