After working to sizably cut our energy allocation in early 2015 as we expected the volatility in oil to continue, we are now selectively adding a few energy names to our portfolio.  Since we have been clanging gongs for a long period of time on the avoidance of high yield bonds financed by US exploration and production (E&P) companies operating in shale basins, has anything changed now that many of these bond prices have collapsed?  Not really.  While we have looked at survivors in the space, it remains a difficult business model to finance with debt and we are already starting to see a wave of defaults in this energy sub-segment, and expect we will see many more.  Ironically, after this restructuring cycle, many of these companies could be financially viable as they have no debt costs to service, which we believe is one of the reasons US production will not collapse going forward.  From the work we have done, $40-$45 oil and limited debt to service could allow these companies to exist even with the drilling treadmill they are on, as costs have come down and efficiencies have improved.

The continued issues surrounding E&Ps have created opportunities in other sub-segments within energy.  The opportunities we are primarily focused on relate to the contagion trade.  By this we mean connected businesses that have been sold down well below what we feel is justified but have different business models.  Midstreamers including pipelines and downstream (refineries)—the companies that process, refine, store, and transport the oil and gas produced by the E&P companies and other chemicals—are examples where we see potential value.  We don’t see huge cash bleeds or defaults on the horizon in many of these connected businesses, and we  see it as a way to benefit from potential upside in oil without having direct exposure to prices.  Many of the midstream players are master limited partnerships (MLPs), which may have to cut or eliminate their dividends.  But by doing so, they are conserving cash to the benefit of servicing their debt.  We also see a likely consolidation cycle coming where investment grade buyers (the TransCanada-Columbia deal as an example) who have a very low cost of capital acquire these high yield companies, allowing them to refinance the debt, capturing massive interest cost savings, and buy this infrastructure cheaper than they can build it, which presents upside for existing debtholders.

Chapter 11 is currently being used as a capital markets tool to reduce debt levels—even for companies that might be able to pull through this current oil pricing environment with existing liquidity, many are instead pre-emptively filing bankruptcy to reduce debt levels.  We see this is a dangerous environment for many bondholders in shale E&P and associated service providers.  90% of defaults so far this year are commodity related.¹  Energy is over 13% of the high yield market² and we do expect defaults to remain concentrated in this sector.  However avoiding energy entirely isn’t the answer.

The current opportunity in selective credits associated with the energy sector actually rhymes with a trade we executed on back in 2002-2003 involving the telecom, media and technology (“TMT”) meltdown.  The victims back then weren’t E&P companies but the Competitive Local Exchange Carriers (“CLECs”).  When they melted down, they dragged down the whole telecom sector, just as we see today.  This included cell tower companies and rural cellular companies, which is where we saw opportunities and focused our commitments.  Those turned out well, while the CLECs themselves basically vaporized.  The “obvious” bargain generally turns out to be the value trap.  But then, as we see now, when you see an entire sector/sectors take a hit, there is generally attractive opportunity to be had somewhere in the space and as a value-based investor we feel it is prudent to see where that value may be.

While in many cases debt will be wiped out and/or equitized, these E&P companies are not going away and we don’t expect a collapse in US production.  These companies will restructure, eliminate debt, and re-emerge from bankruptcy, all the while continuing to produce product to be processed, refined, and transported.  We spoke a few weeks ago about a new high yield index-based exchange traded fund that excludes energy.  Yes, this may help investors avoid the larger concentration of defaults, but it also removes some of the opportunities in the space—yet again another example of why we see active management as so essential in this asset class.  As we conduct our own fundamental analysis and work to gain a true understanding of the business and industry dynamics, we have always been value-based investors, often thematic investors, looking for those companies that we see as under-valued, producing what we see as a healthy yield and capital gains potential for our investors.

¹ Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, April 29, 2016, p. 55.

² Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, April 29, 2016, p. 4.