Energy sector remains weak, but most damage already figured in; hedging may save the day

By Paul Deckelman and Rebecca Melvin

New York, Dec. 5 – The last few months have seen more downs than ups in world crude oil prices, and along with them, slides in the equities, bonds and convertible debt of oil exploration and production companies and, to some degree, in the securities of other companies that work with them, such as oilfield service companies, transportation and storage operators and refiners.

But as bad as things have gotten, market-watchers queried by Prospect News were by no means totally down on the sector.

Among one of the admittedly weak rays of light seen at the end of the tunnel for the issuers and their investors is the likelihood that petroleum prices, which have slid to current levels below $70 per barrel of benchmark West Texas Intermediate crude from the lofty peaks north of $100 they held as recently as mid-July, may have seen the bulk of their downturn and are not likely to fall too much further in the coming months – although there are bearish voices cautioning that this still could happen.

The issuers’ bonds have fallen sharply, with many of what one observer termed “just plain vanilla E&P companies” having slid 20 or even 30 points in recent weeks, and some similar movements in the converts space – but absent serious fundamental problems within those companies, according to the more hopeful view, those securities are not likely to continue losing ground at that pace. Many, if not most of the producers wisely hedged much of their 2015 production against just such an occurrence as we have seen, which should limit further damage to their finances.

For investors, assuming these assumptions pan out, the carnage has already been priced into the bonds – and their reduced prices could present a buying opportunity to pick up some suddenly heftier yields at bargain prices.

Price slide won’t last forever

An analyst who follows high yield E&P companies opined that oil prices are “unlikely to be sustained this low over the long term, at this point – it just does not seem sustainable at the $67 range right now.”

He allowed that he “wouldn’t expect it to rebound, though – to get back to $90 or so over the very near term, certainly absent some sort of supply shock or something that you really can’t forecast.”

But with that having been said, at his shop, “we are currently modeling $65 WTI for all of 2015.”

Another market source conceded that prices probably could head lower in the event that the approaching winter season in the United States, Europe and other parts of the Northern Hemisphere is milder than expected, meaning less demand for refined products like heating oil and a buildup of inventories. But his belief is that a colder winter is the more likely scenario, which would lead to a further drawdown of petroleum inventories, supporting prices.

A trader said that the general consensus for where oil prices may go “is coming in right now,” adding that “you may have an average price of oil at $65 to $70 when all is said and done.”

On Friday, WTI fell 97 cents to settle at $65.84 a barrel, while another benchmark grade, Brent crude oil, slipped 57 cents to settle at $69.07 a barrel. Both grades registered their ninth weekly loss in the past 10 weeks. Those were the lowest closing levels for both grades in more five years; prices slid anew after Saudi Arabia offered its Asian oil customers the biggest discount within recent memory – a signal that it aims to defend its market share.

While there have been some predictions that oil will continue to fall, “I don’t think you’re going to see it drop down to the $40 or $50 level that some people are predicting,” the trader said.

At the other end of the scale, he noted that legendary energy tycoon T. Boone Pickens “came out yesterday and said he sees $100 oil. At some point we may see $100 oil again – but I don’t think it’s going to be in the next year.”

Can oilers weather the storm?

No one disputes that a 40% fall in prices is going to seriously impact revenues at the E&P companies, which in turn will affect their earnings, their free cash flow, and the amount of capital expenditures they choose to make over the next several quarters.

But in a recent research report, strategists at Deutsche Bank noted that the high-yield energy sector “is noticeably tilted towards higher quality, with BB/B/CCC proportions at 53/35/12, compared to overall market at 47/37/17.”

It offered further evidence of this “higher-quality tilt, noting that leverage for the energy sector, expressed in terms of debt as a multiple of EBITDA, came in at around 3.4 times, versus about 4 times for the overall junk market.

“Similarly, their interest coverage stands at noticeably higher levels, even having declined substantially in recent years,” the report said.

Earnings coverage of interest obligations peaked at about 6.3 times for the energy credits in the timeframe of late 2011 and early 2012, while the overall interest coverage ratio for junk credits at that same time topped out in the 4.1x to 4.2x area. It’s been downhill since then, with the energy names’ interest-coverage ratio slipping to around 4.4x by the third quarter of this year, versus about 3.8x for the overall market.

A key factor in the narrowing of that interest-coverage gap between energy and the overall market over the past 2½ years has been the faster pace of increased leverage among the energy names, which has brought energy to its current position as the largest single industry component of Deutsche’s U.S. high-yield index, accounting for about 16% of its market value, well ahead of runners-up financials and telecom, which each account for about 12% to 13%.

With energy names issuing bonds at a red-hot pace during Junkbondland’s new-deal boom over the past few years – as well as actively issuing convertible debt and entering into leveraged loans – “energy issuer leverage has increased faster than that of the rest of the market in recent years, but this trend has largely exhausted itself in recent quarters,” the report said.

It further noted that growth rates in total debt outstanding among domestic junk issuers “have been only slightly higher relative to the rest of HY market” – adding that “with the current shakeout in this space, further incremental leverage will be a lot harder to come by going forward.”

Deutsche said credits in the weakest part of the high yield energy sector – the single-B and CCC segment – are currently trading at levels that have priced in an increased probability of default. The report declared that the actual default rate among those Bs/CCCs is currently running at 3%, “a level that we expect to increase to 5% next year,” while the overall U.S. junk default rate, currently running at 1.7%, is likely to increase to 3.0% next year.

And it warned that a further sustained drop in oil prices down to a $60 level for WTI “is likely to push the whole [E&P] sector into distress,” when the average B/CCC energy name will start trading at a ratio of debt as 65% of total enterprise value – currently, about 28% do – “implying a 30% default rate for the whole segment.”

Hedges to the rescue?

But some of those queried believe that most of the energy companies are positioned to largely withstand the negative impact of continued oil-price weakness.

One market source opined that many of the oilers “have a lot of hedges on for almost all of 2015 at commodity prices that are pretty high.” He said that with that kind of price-protection in place, “the sector, fundamentally, and its issuer companies, won’t feel the pain this year, even though their stock prices have reflected it.”

He predicted that for most names, there would be “almost negligible change” in their forward 12-month EBITDA.

Among specific credits that might fall into that category, another source – Kenneth Duffel, a vice president and credit analyst at KDP Investment Advisors Inc. in Montpelier, Vt. – suggested that “someone like Denbury Resources Inc., for example, has probably got something like three-quarters of their estimated 2015 production hedged.”

He said that additionally, the Plano, Texas-based oil and gas E&P company “has reduced their capital spending by half relative to 2014, and they’re anticipating flat production. So I’d say that‘s a pretty nice position to be going into 2015 with.”

He also cited The Woodlands, Texas-based E&P operator Newfield Exploration Co. as “very well hedged, heading into 2015.”

SandRidge Energy, Inc., has recently been a big mover in the high-yield market, mostly to the downside, but Duffel said that the Oklahoma City-based energy concern is around 40% or so hedged which he called “okay – so, heading into 2015, so they’re not sitting in a terrible position from a hedging standpoint.” He also said that the company “looks like it’s got okay liquidity heading into 2015.”

While Denbury and some others are more than adequately hedged, Duffel said that “on the flip side of that” would be companies like Chesapeake Energy Corp. He said that the Oklahoma City-based natural gas and oil company is “not very well hedged,” with only about one-quarter of its production covered. However, he pointed out that “they’ve got an asset sale that should be closing, so they should be entering 2015 with $7 or $8 billion in liquidity. So I certainly think they have the ability to manage through these type of things.”

Duffel said that “I think your rule of thumb is that your higher-rated BBs look pretty good going into 2015 relative to the oil price environment, and your lower-rated credits – for some of them it could be a bit hairier, certainly.”

On the ropes

In the latter category, he said were underperformers such as Quicksilver Resources Inc. and Venoco Inc., “a completely different story” than their adequately hedged and capitalized sector peers.

A market source at another desk said that troubled Fort Worth-based Quicksilver “is done,” with its 2016 notes currently trading down in the teens and its 2020 and 2021 notes in the low 40s.

A trader said that over the last week or so, the junk E&P sector has seen something of a bifurcation: “the higher quality names are catching and have caught a bid,” and thus have stabilized – for instance, Los Angeles-based E&P operator California Resources Corp., whose several issues of bonds seem to have steadied in the upper 80s.

On the other hand, he said “the lower-quality names in the sector are still kind of under siege.”

He said that “there’s a lot of talk, there’s been names that have been thrown around that are kind of tipping over” – he acknowledged that Quicksilver has been one such name, though by no means the only one.

He continued that “it’s just a matter of if we see oil at these prices or lower for any length of time, you’re going to start seeing these companies tipping over. There’s a lot of chatter about that now and guys are trying to get ahead of that a little bit by selling what they can.”

Buying opportunity?

Another market source said that some of the energy credits that were yielding around 4% before prices began sliding and the sector began shaking out are now yielding 6% or 7% – and some that were already yielding around that level are now yielding as much as 17%.

He said that looking ahead into next year, if by around the end of summer going into fall, “there is a sense that oil has found a bottom – and it doesn’t need to go to $90, it just needs to stop going down,” some investors will look at these kinds of yields and see them as “stupidly cheap” and could step in to do some buying.

And he said that based on conversations he’s had with people in the market, at least some people “are making those bets this week and next week – they’re not waiting till next year.”

Convertibles players watch shakeout

Many of the same dynamics that have moved the high-yield energy sector of late have been evident as well among energy credits in the convertibles market.

There, the selloff that has hit energy names in recent sessions is taking a breather. There seems to be a little stability following the damage done at the end of the last week of November and the beginning of the first week of December, sources said.

But energy convertibles remained in focus. They were trading sporadically however, as buyers were scarce, and opinion remained divided on the outlook for the sector.

Some believe the damage to the energy sector has been done, and now the stabilizing represents a buying opportunity.

Others say the pain isn’t over yet – and that the pain isn’t reserved for only the weakest names. They see the fallout from lower crude oil prices extending beyond the energy sector and filtering into some of the mining and metals names and the industrial sector, a trader said.

With Bank of America having said earlier this week that the price of crude could slump to $50 within a month, one converts trader noted that one analyst made the call that crude would have to go down to $30 a barrel before some of the U.S. shale producers would be unprofitable. If that’s true, then, he suggested, there is more downside to go in the debt of energy companies.

Convertibles market players, while quoting bonds lower in the energy space, pointed out that trading has ebbed and flowed.

“Volume would be higher if there were better buyers for energy,” a New York-based trader said.

Convertibles market-watchers said that each day seemed to bring one or two names that suffered the brunt of selling.

On Monday and Tuesday, Goodrich Petroleum Corp.’s 5% convertibles due 2032 slumped as shares of the struggling Houston-based oil and gas exploration and development company dropped sharply amid growing expectations that the global oil market may not return to normalcy in the short term.

The Goodrich convertibles slipped a point or so to 54 on Tuesday, following a 10-point slide on Monday. Goodrich shares fell another 16% on top of a 22% plunge on Monday.

“There are solvency issues with GDP and Sanchez [Energy Corp.], which is not a convert issuer,” a New York-based trader said. “There are going to be some bankruptcies among the weaker drillers and peripheral players, as oil is going to be weak for a while; it’s not going to snap back.”

On Wednesday BPZ Resources Inc. was in focus as the underlying shares of the Houston-based oil and gas company slid by as much as 50% to as low as 17 cents. The BPZ convertibles traded down to as low as 32. The bonds also traded at 41, a Connecticut-based trader said.

But the overall convertible energy sector was described as firmer, however.

On Thursday, the entire convertibles market felt heavy. Aside from energy, “cash-flow stuff, in-the-money names,” which are less bond-like and more equity sensitive, “were for sale,” a trader said.

Other convertible names that have been in the cross hairs of market player concerns are Energy XXI Ltd., Emerald Oil Inc., and Cobalt International Energy Inc.

Bank of America Merrill Lynch downgraded the energy sector to “market weight” on Tuesday on the heels of last week’s OPEC decision to leave its oil production target at 30 million barrels per day.

The decision not to cut is expected to create over-supply, and Bank of America said that it now expects West Texas Intermediate crude oil to drop to $50 per barrel in the next month.

© 2015 Prospect News.
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