Energy companies’ corporate bonds have been hammered by collapsing oil prices, resulting in massive book losses for investors holding these bonds.
The markdown has been across the board, with many strongly capitalized energy companies’ bonds tumbling along with the debt issues from energy firms with weak balance sheets. The result is a field with both bargains and default risk. But for financial advisors who do their homework, the potential payoffs for their clients are impressive.
For example, Calgary-based TransGlobe Energy Corp.’s 6% issue of non-rated debt, maturing on March 31, 2017, has recently traded at US$96.50 to yield 7.55% to maturity. That’s 661 basis points (bps) over the Government of Canada 1.5% issue due March 1, 2017, recently priced at $101.19 to yield 0.94% to maturity.
Plunging energy prices undeniably have added to energy bonds’ default risk. As of yearend 2014, Southern Pacific Resource Corp., a small, upstream oil producer based in Calgary, announced that it would not make a cash interest payment of about $5.175 million due on its 6% convertible, unsecured subordinated debentures. Southern Pacific subsequently filed for creditor protection on Jan. 22 after Toronto-based credit-rating agency DBRS Ltd. downgraded Southern Pacific’s debentures to C from CCC and its senior secured second lien notes to C from CCC (low). This firm is not alone among oilpatch companies in trouble.
Shoreline Energy Corp., another Calgary-based upstream producer, announced on Dec. 30, 2014, that it would be making a proposal in early 2015 to holders of its convertible debt for “the purpose of facilitating the corporation’s restructuring and strategic corporate transaction opportunities.” Subsequently, Shoreline’s chief financial officer left on Jan. 22 as the firm announced a continuation of a search for strategic alternatives.
Connacher Oil and Gas Ltd. and Laricina Energy Corp., the latter of which admitted default on certain obligations at the end of 2014, also are seeking strategic alternatives.
Many junior oil and gas companies do not have debt issues that are rated. Among those that do, the slide into the troubled waters of C ratings is evident as the decline of oil and gas prices has triggered asset writedowns. These impairments result from the reduced value of specific oilfields in production. Moreover, declining oil prices resulted in a declining return on equity (ROE) of 7.5% for oil producers in 2014, the lowest since 1998, according to a Bloomberg LP report.
At the time of writing, just a month into 2015, the market for speculative-grade corporate debt is not encouraging. High-yield bonds lost 1.55% globally, in U.S. dollars, for the three months ended Jan. 31, 2015, according to the Merrill Lynch master II high-yield index.
The biggest declines have been in the debt of energy producers that issued massive quantities of bonds when oil prices were rising. These companies now account for 13% of the $1.3 trillion of U.S. junk in the Merrill Lynch index, up from 9% a decade ago.
The result of a market drowning in energy debt is that investors are asking for a higher premium to own the debt of even senior firms, such as offshore drill-rig lessor Transocean Ltd., which has investment-grade ratings on its bond issues. This Zurich-based company saw its bonds traded at 360 bps over U.S. treasuries of similar maturities in mid-January. Transocean has US$9.1 billion of outstanding debt, according to the Bloomberg report.
The question for all clients investing in oil and gas company debt is how much wellhead price cuts will impair outstanding debt. Adrian Prenc, vice president with Marret Asset Management Inc. in Toronto, says most firms can survive by cutting capital expenditures and common stock dividends. Even firms with highly leveraged debt should be able to survive and service their debt.
Thus, there are opportunities to be had in certain names, notes Geoffrey Smith, portfolio manager with Lorne Steinberg Wealth Management Inc. in Montreal: “Whether specific bonds are good deals or traps depends on the moving price of oil and the subsectors in the oil business [and] also depends on the leverage of each company. We are underweighted in energy-sector debt, but we do hold an Athabasca Oil Corp. bond with a non-investment-grade B rating from DBRS.”
The Athabasca bond is a 7.5% issue dated November 2012 and due in November 2017, recently priced at $83 to yield 15% to maturity. That’s 1,399 bps over the 1.5% Canada issue due Sept. 1, 2017, recently priced at $101.28 to yield 1.01% to maturity. “[Athabasca] has the cash to pay interest due, so we think [the bond] is worth holding,” Smith says.
The high yield of small energy companies’ bonds reflects not only risk, but liquidity. “More money has moved into high-yield bonds in the past three or four years because of low prevailing interest rates in investment-grade bonds,” Smith adds. “Banks are holding smaller inventories on their bond desks and, as a result, liquidity in all bond trading has declined.”
In fact, corporate bond trading is down by as much as 70% since 2008, according to the Bloomberg report, creating an illiquidity premium for holders of all bonds other than new issues actively traded in the on-the-run market.
“Lower wellhead oil and gas prices have tainted investors’ view of upstream oil producers, but there are gems in the rubble,” says Derek Moran, president of Smarter Financial Planning Ltd. in Kelowna, B.C. “The advisor needs to do a lot of research to find the bargains and to diversify risk. But the vast and very attractive spreads on yields to maturity show how profitable that research can be.”
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