Bonds In Small, Likely Highly Successful Oil And Gas Explorers And Producers May Lift Your Portfolio.

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 |  About: Diamondback Energy (FANG), ATHL
by: David White

Summary

Moody's upgraded Athlon Energy's liquidity rating to SGL-2 from SGL-3 on September 6, 2013. It may be in line to receive a further upgrade.

Moody's upgraded Diamondback Energy's Corporate Family Rating to B2 from B3. FANG may be in line for another upgrade within a year.

Read further to learn more details about these issues. Upwardly trending bond ratings mean both ATHL and FANG are likely better bond and stock buys.

Bond prices are so low right now that most people are hesitant to buy them, especially when the Fed has said that it will soon start raising its Fed Funds rate. Yet investors face what is looking more and more like a near term market pullback of 10%+. Plus there is the specter of a bear market on the horizon; and that typically means an overall market drop of roughly -40% from the highs over an approximately two year period. Many do not believe politicians will allow a bear market to start until after the midterm elections in November 2014. Therefore much of the immediate concern is about a possible near term pullback. An article, "16 Good Reasons To Be Wary Of A Market Downturn", covers this topic more thoroughly for those readers who are interested.

The question then becomes, what do investors do with their money? Some investors will not want to take any chances. They will put their money into US Treasuries; but even this can be fraught with peril. Short term US Treasuries pay very little. The 2 year yield is 0.46% as of August 5, 2014. Longer term US Treasuries pay only moderate yields. The 10 year yield is only 2.48% as of August 5, 2014; and investors in these securities face extension risk. That is they may get locked into a low interest rate for a long period of time, when interest rates are rising. If they try to get out of these securities in a rising interest rate environment, they face the loss of principal because low interest rate bonds become worthless in a higher interest rate environment. Bond buyers seem caught between a rock and a hard place.

I have a suggestion that some investors with a modicum of risk appetite may like. This effectively amounts to betting on certain publicly traded companies without facing the growing probability of rapidly falling stock prices in the near future. My stratagem is to identify a secular bull trend. Since I am well versed in energy, I have chosen this one. Many think that energy prices are virtually sure to go up long term because the emerging market economies will demand more energy as they grow. This should provide for steadily rising oil and natural gas prices over the long term. The chart below from the "BP Energy Outlook 2030" shows that the Non-OECD energy demand is expected to roughly double by 2030.

The chart below again from BP breaks the energy growth up by fuel type.

Overall "world primary energy consumption is projected to grow by 1.6% per annum from 2011 to 2030, adding 36% to global consumption by 2030. The growth rate is expected to be 2.1% per annum for 2010-2020." A world economic slump, which is a possibility in the near future, could cause prices to fall temporarily; but they would likely rebound in a short time due to solid long term fundamentals. Plus even in the case of an economic slowdown due to an economic war with Russia, the US and the EU could see oil and gas prices rise. Russian oil production for June 2014 was 10.55 million bpd. To ballpark this, total world oil supply for April 2014 was 90.30 bpd. If a good portion of the Russian oil were taken off the market by either Russia and/or by economic sanctions, that would put a huge dent in world oil supply. It could well cause oil prices to skyrocket. Down isn't the only way oil prices can go in an economic downturn.

In addition to the mounting worries about Russian energy supplies, there are worrisome situations in Iran, Iraq, Libya, Nigeria, etc. Any or all of these could cause disruptions in world energy supplies that could cause world energy prices to rise.

My theory is to select some of the smallest and best US oil companies (oil prices have been more stable than natural gas prices) to buy the medium term corporate bonds of. These small, hot companies should be able to weather a US economic downturn, but because they are relatively young and small, they will have high bond yields. Plus the bond prices of those bonds seem likely to rise as the companies become more successful. Further as the bonds over time become shorter term bonds, their prices should rise eventually for that reason, even if interest rates go up. For example, a 7 year 7.5% yielding bond would almost surely have a higher price if it were only two years from maturity. This phenomenon should allow investors to get their money out of these bonds if they so choose. Plus the secular bull market in energy and the quality of the energy growth companies invested in should ensure that the bonds will remain good, even if the companies invested in are small.

One way of giving yourself an edge is to select good oil and gas growth companies that have semi-recently gotten credit upgrades. Two small, high growth oil and gas companies that fit this description are Diamondback Energy Inc. (NASDAQ:FANG) and Athlon Energy Inc. (NYSE:ATHL). I am sure there are many more. I may write further articles about them; but let's review these two for now.

On September 6, 2013 Moody's changed Athlon's outlook to positive; and it upgraded its liquidity rating to SGL-2 from SGL-3. It affirmed Athlon's B3 Corporate Family Rating, its B3-PD probability of default rating, and its Caa1 senior unsecured note rating. Moody's said, "The positive outlook reflects our belief that Athlon will be able to steadily grow production and reserves through 2014 and improve on its leverage metrics. An upgrade is possible if the company can achieve production volumes approaching 18,000 boe/d while reducing the debt to average daily production ratio below $35,000 per boe/d. A sustained drop in production or weak liquidity could prompt a downgrade. If combined cash and revolver availability falls below $50 million, or debt to average daily production rises above $55,000 per boe/d level, a downgrade is likely."

Athlon priced a new secondary offering of 12,500,000 shares common stock at $46.25 on July 31, 2014. The underwriters have a 30-day option to purchase an additional 1,875,000 shares at the public offering price. After the completion of this, Athlon seems unlikely to run up against any of the negative triggers mentioned above. In fact Athlon's average daily production in Q2 2014 reached a record high of 21,901 Boe/d compared to 11,183 Boe/d in the year earlier quarter. According to Moody's statement from last year Athlon Energy may be in line for a credit upgrade. This could be a good time to buy Athlon bonds. Athlon's operating profits are 2.5 times greater than its interest payments. There should be little problem in repaying debts. Further Athlon's long term debt to total assets ratio as of March 2014 was 0.37. This was down from the year earlier figure of 0.45. This is the kind of trend investors wish to see.

The most recent offering of Athlon bonds was a May 1, 2014 offering of $650 million of 6.00% senior unsecured notes by Athlon Holdings LP and its co-issuer and wholly owned subsidiary, Athlon Finance Corp. These notes were issued privately to qualified institutional buyers in the U.S.; but some investors may be able to find some available. If not they may be able to find other Athlon bonds available. Alternatively investors may be able to find a junk bond fund or two (an institution) that invests in these bonds. Such a fund may have a similar thesis to mine.

On July 22, 2014 Moody's upgraded Diamondback Energy's "Corporate Family Rating to B2 from B3, its probability of default rating to B2-PDR from B3-PDR, and its senior unsecured note rating to B3 from Caa1. Further the rating outlook was changed to positive from stable; and the Speculative Grade Liquidity Rating was affirmed at SGL-2. Moody's says a further upgrade can be considered if FANG raises its production to near 30,000 Boe/d while maintaining the debt to average daily production ratio under $35,000 per Boe/d."

FANG's current interest coverage is 4.41x (from TD Ameritrade). In other words FANG can easily pay its debts out of its profits. To put a further upgrade in perspective, FANG's Q2 2014 production was 17,800 Boe/d. This was up 32% from Q1 2014 and 171% from Q2 2013. At a somewhat slower rate of growth for the next year, FANG might be able to glean another upgrade from Moody's within a year (by reaching production of 30,000 Boe/d). That would bring it to a B1 rating, which is quite good for a small company. However, the main point is that the direction of FANG's credit quality is upward at this point; and it is sufficiently good as of July 22, 2014 to make FANG an attractive junk bond investment.

To add to production, FANG signed a Purchase and Sale Agreement ("PSA") on July 18, 2014 (after Q2E 2014). This acreage (13,136 net acres in the Midland Basin) had current production of 2,200 Boe/d and about 5.2 million Boe of proved developed reserves. This property is in close proximity to other FANG acreage. It should be a good fit; and it brings FANG's total production to approximately 20,000 Boe/d. This makes it likely that FANG can achieve a further credit upgrade within a year based on increased production. Remember the level of production Moody's said it wanted for this was approximately 30,000 Boe/d. From FANG's interest coverage ratio, it is still well within respectable limits with respect to being able to repay its debt. The new purchase for $538 million cost $24,455 per Boe/d, which is below Moody's requirement for production acquisitions or organic production achievements to cost below $35,000 per Boe/d. From a credit quality standpoint, FANG looks like a great credit buy.

I could find no bond data available for FANG with Morningstar; but it has $587 million in long term debt (Yahoo Finance). Someone must own that debt. Plus FANG is certain to access the bond market as it grows further. With the still low rates as of August 6, 2014 and FANG's recent credit upgrade, the likelihood of this is high. FANG has gotten to the point where it will soon think it is cheaper to access the bond market than to sell more equity. This will be more true if we see a bear market in the near future. If FANG's stock price falls significantly in that bear market, the company and investors will be reluctant to sell more stock at a much reduced price. Rather it seems likely that the company will seek funding from the bond market. They might well view it as less dilutive. Some may think this is useless information; but chance favors the prepared mind. Picking up FANG debt within the next year may be a good move.

Further the above examination of the credit quality of FANG and ATHL gives investors another good piece of information for deciding whether to invest in FANG and/or ATHL. Both appear to be great growth oil and gas companies. The fact that each is seeing credit upgrades is a big positive if one is thinking of investing in them. A stock price often follows the credit trend for a small company, especially a small, high growth oil and gas E & P company.

The two year chart of ATHL provides a good look at the trajectory of its stock price.

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The two year chart of FANG provides a good look at the trajectory of its stock price.

Click to enlarge

Both of the above charts look strong. FANG's looks extremely strong. Not surprisingly it had the better credit profile (a B2-CFR versus a B3-CFR) and a better interest coverage statistic. Even if investors do not end up investing in FANG or ATHL debt instruments, this article provides information that can be used to decide whether or not to invest in either or both of these stocks. Both are near oversold area on their slow stochastic sub charts. FANG especially has a history of rallying off slow stochastic lows.

If oil starts to rally again, both of these oversold stocks are likely good vehicles to pursue a short term rally in oil prices. FANG has a PE of 49.27 and an FPE of 19.73. It has an average analysts' FY2014 EPS growth forecast of 129.80% and a Next 5 Years EPS Growth per annum forecast of 60.00%. ATHL has a PE of 51.21 and an FPE of 17.98. It has an average analysts' EPS Growth forecast of 53.20% for FY2014 and a Next 5 Years EPS Growth per annum forecast of 50.00%. These are the kind of stocks HFT/momentum traders tend to flock too. They seem likely to provide short term traders with help in making short term profits by capturing large, quick moves upward.

Both of these stocks are stocks investors will want to watch closely. If you can pick the right entry time, you should be able to make a lot of money on either of them. For now oil prices and the overall market represent a "falling knife", which by adage investors are not supposed to try to catch. However, some day traders may want to trade in these stocks; and some investors with a long term horizon may want to consider buying them now. Both stocks seem solid investments for the long term. The average analyst seems to agree with my opinion with a mean recommendation of 1.8 (a buy) for FANG and one of 1.9 (a buy) for ATHL.

Investors may be able to invest in the bonds of these companies in the near future. However, regardless of whether they can invest in these particular two, the thesis of this article is a good one; and it applies to other companies as well. For instance, Chesapeake Energy (NYSE:CHK) has more widely available bonds. Its Corporate Family Rating was upgraded to Ba1 from Ba2 on May 20, 2014 by Moody's. It is another oil and gas E & P company with an upwardly trending credit rating and quickly growing oil production, although it is not a particularly small company.

NOTE: Some of the above fundamental fiscal data is from Yahoo Finance or TD Ameritrade.

Good Luck Trading.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in FANG, ATHL, CHK over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.