Low Prices May Turn These ‘Fallen Angels’ Into Solid Investments

The price of a barrel of oil has rebounded from February lows, but most analysts are not yet ready to sound the all-clear on the sector. Promises of a production cap from OPEC and Russia mean little without action, and North American production has yet to come down appreciably.

#-ad_banner-#The plunge from $105 per barrel has been a nightmare for exploration & production (E&P) companies, sinking the price of their shares along with revenue. 

However, it hasn’t all been dark clouds for companies in the space. In fact, a few are taking advantage of fear in the market to position themselves for faster growth when energy prices rebound. These proactive companies will emerge as some of the most financially fit, and investors may want to follow their lead. 

A Financial Silver Lining On Energy Storm Clouds
The price of oil has come down slightly from its 50% rally off of February lows. The industry isn’t yet out of the woods after price drops of nearly 75% in less than two years, but there does seem to be a renewed optimism in energy. 

That sense of optimism is giving companies in the E&P space the power to do something very proactive, a move that could lead to much faster growth when energy prices recover.

Bloomberg reports that several Canadian energy companies, notably Encana (NYSE: ECA) and Repsol (BME: REP), are using excess cash and credit to repurchase bonds that have been rocked by the collapse in prices. Over the last two years the fear of uncertainty has driven bond prices of energy companies to steep discounts. The value of junk-rated debt issued by U.S. energy companies slid in February to a two-decade low at $0.56 on the dollar, below where it traded during the 2008 financial crisis. Bond prices have rebounded somewhat with the rally in crude but still trade for steep discounts to par value.

Energy companies with the financial ammunition available are taking advantage of this to buy up their bonds. Encana offered to repurchase $250 million of four long-dated bonds on March 16, using cash and available credit facilities.

The repurchases do several things for the companies. An immediate savings is booked in annual interest expense on the bonds and hundreds of millions are saved compared to waiting to buy the bonds back at maturity. The move also helps to reduce net leverage and improve balance sheet health. If the rally in energy prices becomes a full-blown recovery, these companies will be primed with borrowing ability to jump on new projects.

Two Fallen Angels With The Most To Gain From Bond Buying
On January 22 Moody’s put more than $500 billion of energy company debt on review, and 10 days later Standard & Poor’s Ratings jumped in with a massive downgrade of ten companies. Some of these downgrades took the companies’ rating into non-investment grade, causing rates to soar and bond prices to plunge. 

It’s these ‘fallen angels’ that have the most to gain from buying back their debt and where investors should start their search. I crossed this list with a search of companies that still had significant credit available through lending facilities and strong assets that will help them weather the storm.

Southwestern Energy (NYSE: SWN) was downgraded to BB+ by Standard & Poor’s Rating in February. The firm’s 2025 bond (4.95% coupon) is trading for $0.69 on the dollar. Retiring the one billion in 2025 bonds would clear 21% of the firm’s $4.7 billion in debt, save $49.5 million in annual interest and $310 million by not having to pay the bond at maturity. SWN historically carries a low cash balance but has approximately $1.95 billion of its unsecured credit facility available. 

Revenue dropped 22% last year and is expected to fall another 30% this year before rebounding in 2017. The company’s 2016 budget calls for an 80% reduction in capital spending from last year, freeing up lots of cash for other uses. Shares are trading for just 0.9 times trailing revenue, less than a quarter the five-year average multiple of 3.8 times revenue.

Continental Resources (NYSE: CLR) was also downgraded to junk by S&P in February. The firm’s 2044 bond with a 4.9% coupon is trading for $0.72 on the dollar while the 2024 bond trades for $0.80 on the dollar and carries a 3.8% coupon. Retiring the $700 million in 2044 bonds would clear 10% of the firm’s $7.1 billion in debt, save $34 million in annual interest and $196 million by not having to pay the bond at maturity. The firm has $1.9 billion available under its revolving credit facility. 

Revenue is expected to surge 29% to $2.46 billion next year after expectations to post $1.9 billion this year. The company has a strong competitive advantage in recently added SCOOP (South Central Oklahoma Oil Province) and STACK (Sooner Trend, Anadarko Basin, Canadian and Kingfisher counties) production regions which will drive sales when prices recover. Shares are trading for just 2.3 times trailing revenue, less than a half the five-year average multiple of 5.1 times revenue.

Risks to Consider: Bond prices have fallen because of fear for financial distress on low energy prices. Even with healthier balance sheets, shares of these companies could be volatile until oil prices head higher.

Action to Take: Position in large energy companies that might be able to use the crisis in oil prices to improve their financial health and drive future growth.

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