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Equity Perspectives

Amid signs that oil prices may have bottomed out, value and restructuring plays have surfaced in the exploration and production sector. Lord Abbett analysts drill down on the prospects.

 

In Brief

  • World oil supply is high, but starting to contract.
  • Oil demand growth was very strong in 2015, and will likely grow in 2016, albeit at a slower pace.
  • While many actively managed fixed-income and equity strategies were underweight the oil sector relative to their benchmarks through most of the commodities correction, some shifted to an overweight of the exploration and production (E&P) sub-sector in early 2016.
  • Within fixed income, the high-yield debt issues of energy companies with solid assets and liquidity appeared attractive in early 2016.
  • On the equities side, small- and mid-cap E&P companies may represent attractive value, while large-cap, integrated oil companies have slashed capital spending to improve cash flow and maintain their dividends.

 

Has the oil market reached a turning point, as recent media reports suggest? Or is this just a case of misplaced optimism about the current supply/demand imbalance?

“The global oil market remains oversupplied by 1–2%, which makes a big difference to prices, but the amount of oversupply is narrowing,” said Yoginder Kak, energy analyst with Lord Abbett’s global equity research team. Even so, overleveraged exploration and production (E&P) companies most exposed to the shale boom remain pressured, and demand for oilfield services certainly has shrunk.

“I think you still need to be cautious,” said Andrew Bernstein, a Lord Abbett research analyst who covers fixed-income securities in the E&P and services sectors. “Remember last May and June, when oil prices rallied to the high $50s and low $60s [per barrel], only to plummet to a nadir of $26.21 per barrel in mid-February, as Russia and Saudi Arabia pumped near record highs? That prompted companies worldwide to further curtail spending and output plans.” And with recent OPEC [Organization of the Petroleum Exporting Countries] talks on production curbs stalling, so has the sharp rally in crude prices that began in February.

Glut Reaction
Against that backdrop, the glut of U.S. oil is finally showing signs of easing. “We anticipate there should be an acceleration of U.S. production cutbacks as you get to the second half of 2016,” said Bernstein. “And that has given the market a psychological boost.”

Bullish as that sentiment may sound, many market participants are still waiting for further declines in global oil supply (see Chart 1) amid a massive inventory overhang in all forms of storage and a gradual increase in demand (see Chart 2). Barring some kind of geopolitical disruption, a catalyst for further oil price appreciation may not happen until 2017, which suggests oil could trade between $30–50 per barrel for the next 12–18 months, according to some market watchers.  

“While production is coming down, you always have to be wary that if the price gets ahead of itself, some companies will lock in hedges [in the futures market], and then bring rigs back into service,” said Bernstein. “If they start producing again, the supply problem could stretch out even further.”

Economic improvement in China, the biggest consumer of crude oil after the United States, might help. So would a pickup in emerging-market economies linked to growth in China. Whether such increased demand is offset by Iran’s plans to ramp up oil production is another matter.

It remains to be seen if Iran can get all its curtailed oil (approximately 500,000 barrels per day) back on the market. “Even if they do, it’s difficult for many countries to import Iranian crude,” said Bernstein. “One challenge is finding the necessary trade financing, given the many regulations on doing business with Iran.” U.S. banks, for example, cannot fund international entities that want to import Iranian crude. And there are all kinds of debates about the ultimate destination for such crude and how it will get on ships.”

 

Chart 1. World Oil Supply Is High, but Starting to Contract
Million barrels per day (mb/d), first quarter 2013 – first quarter 2016


Source: International Energy Agency.

 

Chart 2. Oil Demand Should Gradually Pick Up in 2016
World oil demand, first quarter 2013–third quarter 2016E, million barrels per day (mb/d)

Source: International Energy Agency. 

 

Re-thinking E&P
While a number of actively-managed fixed-income strategies were underweight the oil sector through most of the commodities correction, some shifted to an overweight of E&P in early 2016, as the high-yield issues of companies with solid long-term fundamentals and no trigger for default appeared attractive.   

A number of the high-yield bonds issued by these companies rallied in April, but active managers with rigorous research discipline continue to see opportunity.

“Some companies with elevated debt-to-EBITDA ratios are being disproportionately penalized by the market. However, a number of these companies are actually somewhat interesting as they have good assets, and will not go into bankruptcy simply due to a leverage ratio of seven or eight times,” Bernstein said. “A company goes bankrupt if it runs out of liquidity…”

Suppose a company has a highly levered balance sheet, but sufficient liquidity to fund its operations through at least 2017. That scenario might appeal to investors who envision that oil supply and demand eventually will reach some sort of equilibrium, boosting prices beyond the current trading range. “If you believe that, then these companies should be able to delever organically over time,” Bernstein added.

Dressed for Distress
According to the law firm Haynes and Boone, 59 North American oil and gas producers have filed for bankruptcy since the beginning of 2015. (See Chart 3.) These bankruptcies involve approximately $22.5 billion in cumulative secured and unsecured debt. Seventeen of those producers filed for bankruptcy so far this year (as of April 3, 2016), and all indications suggest many more producer bankruptcy filings will occur during 2016, Haynes and Boone reports.

For some fixed-income portfolio managers, all that distress creates potential investment opportunities – many firms are involved with the creditor committees of various troubled companies that are seeking to restructure their finances.

One method under discussion is what’s known as a prepackaged bankruptcy (“prepack”), whereby a company files a plan of reorganization that already has been accepted by creditors.

Suppose, for example, that a company has solid assets, an overleveraged balance sheet, and a relatively simple capital structure—meaning there’s a bank credit facility and maybe one series of bonds. 

In one prepack scenario, bondholders might be willing to swap their senior claims on the company’s assets in return for reorganized equity with considerable upside potential in a new capital structure. This complexity highlights the importance of sector specialists evaluating such opportunities. This type of restructuring would right size the capital structure, eliminate a large amount of interest expense, and enable the company to operate at least near free cash flow neutral until commodity prices rebound. 

“Prepacks are very dynamic,” Bernstein said. “There are lots of factors at play, such as competing interests between creditor and equity committees, as well as management teams that are seeking a portion of the reorganized equity as compensation to run the business going forward.”

 

Chart 3. Dire Straits: 63 Oil and Gas Bankruptcies in 16 Months
Cumulative North American E&P bankruptcy filings, 2015–2016 (through April 15)

Source: Haynes and Boone Bankruptcy Monitor. 

 

Shale versus “Big Oil” 
On the equities side, one investment theme has been to focus on small- and mid-cap E&P companies in shale regions that were selling at a discount during a down cycle—producers with good underlying assets that can survive even if the slump were to drag on.

“Purely picking the cheapest valuation companies hasn’t worked in the E&P space for the last several years, because there have been sustainable differences in asset quality,” said Kak. “Companies with good asset positions have in general continued to do well, and the ones without them have not. So, our focus has been on identifying companies with good, sometimes underappreciated assets that are not the most richly priced but have the potential to improve over time.”

Asset quality in this case is defined as the economics of wells that companies are drilling. Wells could be in the same general shale formation, but returns on investment in core areas may eclipse those in peripheral areas with lower yields.  

As for “Big Oil,” large, integrated oil companies traditionally have been core, go-to holdings in large-cap portfolios. But now that the spread between their returns on capital and more pure-play E&Ps has narrowed as a result of the shale-boom era, their leadership position has been challenged. 

As the costs of extracting shale oil and gas by hydraulic fracturing and horizontal drilling dropped, integrated oil companies less exposed to shale invested in more capital-intensive projects with longer lead times. As oil prices dropped, the returns on such projects dropped, particularly abroad.

“Integrated oil companies may not deserve the premium that they used to, but they are still well run and don’t destroy value the way some E&P companies have in the past,” Kak said. “And after slashing capital spending, their cash flow and production profiles look better than they have over the last five years—all of which helps explain why the dividends of the largest integrated oil companies have held up well.”

While the oil market may be on the path to rebalancing, the primary risk going forward will be global economic activity. If demand growth doesn’t materialize, energy companies currently being valued as if oil prices will be in the low to mid-$60s per barrel may be in for a “crude” awakening.

“All the more reason to be selective about oil stocks,” said Kak. 

 

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

A Note about Risk: Investing involves risk, including possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Bonds may also be subject to 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. 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. No investing strategy can overcome all market volatility or guarantee future results.

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. 

Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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