The precipitous decline in oil prices that began in late 2014 has shaken investors and humbled governments. While the market for crude has stabilised of late, it remains volatile enough to warrant significant caution from investors.
We are not oil bulls; indeed, within the Old Mutual Global Investors credit team we pared our exposure to oil and gas companies over the course of last year. But select opportunities for bond investors do exist – they just require extensive research and a steady nerve.
One such opportunity we saw last year was Whiting Petroleum, a Colarado-based independent exploration and production firm. The company acquired a rival, Kodiak Oil & Gas, in late 2014 – shortly before the oil price began to head south.
As part of the takeover, Whiting assumed $2.2bn (£1.56bn) of Kodiak debt, including $800m of bonds maturing in December 2019 that paid an annual coupon of 8.125 per cent. A comparable security of Whiting’s yielded less than 6 per cent. The 8.125 per cent Kodiak bond was callable from December 2015 – meaning the company could buy it back – at a higher price than that prevailing in the market.
From our analysis of the company and the capital markets, we concluded that Whiting was likely to call and redeem these more expensive bonds. These bonds were redeemed in December 2015, offering investors a solid total return on their investment.
While we follow many companies in the US oil and gas sector, there are two that we find particularly interesting for somewhat different reasons: Concho Resources and Newfield Exploration, both Texas-based exploration and production companies whose high-quality assets set them apart when the oil price tumbled.
These companies benefit from low leverage relative to their sector, experienced management teams and supportive equity and debt investors. Moreover, they hold more oil than gas assets. Given the current market backdrop, Concho is very much the ‘pretty sister’ of the pair with a higher proportion of oil-based assets.
Essentially, our analysis indicated that although the prices of Concho and Newfield’s bonds are highly correlated with oil prices, the volatility is dampened due to the reasons stated above and the companies’ prudent capital management. The graph below compares the total returns from a Concho bond maturing in 2022 and a Newfield bond maturing in 2022, with that of the BofA Merrill Lynch US High Yield Energy Index, underscoring this point.
Despite the recent bounce in prices, we continue to see the short-term outlook for oil as unclear, given the continuing oversupply. There has been little fundamental support for the move to higher prices, which is actually something of a self-defeating mechanism. If prices rise too high, too soon, the production capacity that needs to be taken out of the market – to correct the supply overhang – will remain.
As our research has revealed, there continues to be value in the oil sector – as long as one follows a disciplined bottom-up, research-driven approach.
Oil bond returns vs the BofA Merrill Lynch US High Yield Energy Index.
Deepa Abraham is senior credit analyst at Old Mutual Global Investors