The E&P Sector: What Is The Right Play Here?

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Includes: AE, APC, AREX, AXAS, BBEPQ, BBG, BP, CHK, CLR, CRK, CVX, CWEI, DUK, EOX, EXXIQ, GDPM, HK, LINEQ, MRO, NADL, PBR, PKD, PQ, PVAHQ, PWE, REN, REXX, RIG, SD, SDLP, SDRL, SN, WLL, XCO, XOM
by: Marquez Capital Management

Summary

A basket-style investment in the E&P sector makes sense because of balance sheet uncertainties and questions about the long-term survival of particular micro-cap names.

The American shale and offshore industries will survive the current OPEC-driven downturn, regardless of what happens to particular micro-cap E&P companies.

Any investment in the E&P sector needs to be balanced with investments in integrated oil and gas giants, for the sake of stability and risk management.

Everyone knows that the zero-interest rate (ZIRP) environment, which was dominant for so long under the policies of the Bernanke-Yellen Federal Reserve, produced a setting in which money flowed incredibly freely toward high-yield, risky ventures. The availability of this money to persons in the energy industry promising big dreams is hard to overstate. Everyone also knows that the easy high-yield money has been drying up in the last several months in the oil patch, especially among the micro-cap and small-cap E&P names. In addition, the negative press coverage and political pressure which has been exerted recently by the broad-based Paris agreement upon the international energy sector's production of greenhouse gas emissions have been immense. The International Energy Agency and similar groups have in recent months been pressing especially hard for reductions in the indirect subsidies that historically have been given to oil, gas, and coal companies.

What everyone doesn't seem to see is that the actual financials of at least some of these high-yield E&P companies suggest that they perhaps have been oversold by the market alongside other, weaker peers - even though there's been a small price recovery in the last week. Examples are Abraxas (NASDAQ:AXAS), Whiting (NYSE:WLL), Sanchez (NYSE:SN), Bill Barrett (NYSE:BBG), and, in the offshore sector, Transocean (NYSE:RIG). Each of these companies has had declining margins, declining revenue, and increasing D/A ratios. But each of these names also has enough balance sheet liquidity to last through 2018 with Brent and WTI at current prices (of course, senior debt holders almost certainly would begin imposing credit crunch restrictions prior to that time, but that is an article for another day). Their equities are behaving as though their bankruptcy is imminent.

For these reasons I propose an experimental portfolio of a sampling of the equities of some small oil patch E&P companies, in the expectation that some of them will survive the current downturn even as others will probably not. The market panic of early January has passed, and I do not expect a sudden downturn like we saw then in the near future for these equities. Companies whose equity prices have been decimated and which represent a real roll of the dice include Approach Resources (NASDAQ:AREX), Breitburn Energy Partners (NASDAQ:BBEP), Comstock Resources (NYSE:CRK), Emerald Oil (NYSEMKT:EOX), Energy XXI (NASDAQ:EXXI), Goodrich Petroleum (NYSE:GDP), Halcon Resources (NYSE:HK), Linn Energy (NASDAQ:LINE), North Atlantic Drilling (NYSE:NADL) - an offshore name, Parker Drilling (NYSE:PKD), Petroquest Energy (NYSE:PQ), Penn Virginia (NYSE:PVA) - currently on the Pink Sheets, Penn West Petroleum (NYSE:PWE), Resolute Energy (NYSE:REN), Rex Energy (NASDAQ:REXX), Sandridge Energy (NYSE:SD) - currently on the Pink Sheets, and Exco (NYSE:XCO). If and when some of these companies survive, it will be a coup for their management teams. A couple of these companies have already entered into some form of restructuring/restructuring negotiations with their creditors and/or are now trading on the pink sheets.

Companies which are in substantive distress but which have slightly more respectable balance sheets include Bill Barrett, Clayton Williams (NYSE:CWEI), Sanchez, Chesapeake (NYSE:CHK), Seadrill (NYSE:SDRL), Marathon Oil (NYSE:MRO), Abraxas Petroleum, and Seadrill Partners (NYSE:SDLP) - a daughter company of SDRL.

Again, slightly larger companies which have suffered equity distress but which will almost certainly, via hedges and economies of scale, survive a further oil downturn for at least a few years include Duke Energy (NYSE:DUK), Continental Resources (NYSE:CLR), Whiting Petroleum, Anadarko (NYSE:APC), Transocean - a rig supplier, and Adams Resources and Energy (NYSEMKT:AE).

Investors who are interested in investing in a basket of these oversold names can buy this "Cautious E&P Turnaround" portfolio in a single transaction through Motif Investing (and collect a $100 sign-up bonus if they do not yet have an account with Motif). The portfolio in this sector that I favor at this point is diversified with approximately 20% long the riskiest E&P names with the most substantial upside in the event of a bullish turnaround; 20% in a collection of integrated large-cap companies like BP and Chevron that have stability and that are unlikely to see a lot of further downside at this late stage; 20% in semi-risky E&P companies that are likely to survive through 2018 in the event of a further bear market; 20% in non-risky E&P companies that in almost any scenario will survive a long-term energy downturn; and 20% in straightforward energy ETFs for the sake of portfolio stability. While I really have no idea what return such a portfolio will achieve in the coming year, my expectation - based on a history of cautious, reasonable downturn commodity investing - is for something in the 35-50% range. While I am intentionally limiting my upside by including in the portfolio a number of safe and boring energy plays, I also am diversifying it into the riskier E&P securities as well, so as to harness their leveraged upside in the event of a turnaround.

In my view, the equity prices in this sector have been so badly beaten down that the recovery upside of the E&P names which have been mistakenly sold off is more than likely to offset the losses of the names that really will go bankrupt. I am willing to stick with this strategy even up to a 30-35% bankruptcy rate of the companies in the portfolio. A basket-style strategy makes sense here because of different companies' balance sheet ambiguities, because of the massive risks in the sector, and because of the sector's precarious market dynamics (i.e. Saudi market manipulation, M&A contingencies, etc.). Outperforming market investments only outperform because of market inefficiencies. So, is there inefficiency here? The inefficiency in this sector, if there is one (and I'm willing to acknowledge that there might not be one), is that some of the smaller E&P companies have been considered by the market to be guilty by association, and have been sold off in discriminate fashion because of panic or fear, 2015 year-end tax loss selling, peer pressure, and so forth.

Why these particular E&P companies?

One approach to investing in this sector is to do a deep dive into the fundamentals of particular companies. When evaluating the equities of particular independent E&P companies, one of the main things that investors ought to look for is the ability of the companies to access capital without having to dilute shareholder value. Also, small and independent E&P companies typically are in much stronger financial positions when they have minimal debt or at least the ability to service their debt in ways that are responsible and that do not do damage to their long-term financial position. Investors considering positions in this space should look for management teams that are experienced in a variety of different areas of the energy sector - exploration, technology, or financial management. Investors should also consider hedges and determine which players in this space are sufficiently hedged to survive a multi-year downturn.

But at the same time, even in spite of the precautions of deep dives into the fundamentals, the high-yield debt market has dried up for these small companies. The smaller the company, the smaller the balance sheet and the less it is likely to be in control of its fate in a low-price Brent and WTI environment. If Saudi and its Persian Gulf allies decide against all odds to keep pumping (even in spite of their $98B yearly deficit), there will be some small E&P names that will fail even though they have tried everything possible to improve their balance sheet, push back covenant agreements, and lower their drilling price points. Thus diving deeply into the fundamentals of particular companies might not necessarily be a successful use of one's time in this circumstance, given that a good number of them will have little control over their fates.

Instead, what I think makes sense here is a play that expresses my confidence in the survival of the American E&P sector as a whole. I mean especially shale oil, but also to some extent the offshore industry as well. The drilling technology is constantly improving, and even though individual companies will fail, the sector as a whole is almost certainly going to survive the decimation of OPEC's assault. Thus, what is sensible is a basket-style investment strategy that focuses on names that exhibit a spectrum of the risk in the sector: some that are high-risk, some that are high but lesser risk, and some that are medium risk (probably only the integrated multinational corporations are low-risk, so since this is a small speculative portfolio I will not be including them here). Some of the high-risk names will fail, but others in the basket will not and their upside rebound will probably more than offset the failure of the high-risk names.

Another advantage of the basket strategy: micro-cap upside

Again, setting aside the massive panic in the sector (which arguably has produced the outperforming opportunity I am describing), part of the reason why a basket-style investment of this kind makes sense here is because of the longstanding scalability advantages of small-cap companies. Generally speaking, small companies like the E&P names I am highlighting have scalability advantages over their larger counterparts, and as such they have the potential to deliver higher returns. In the event of an oil recovery in the next two years, their advantages over larger, integrated oil and gas giants like Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), and BP (NYSE:BP) are substantial. In addition, a basket-style investment in small companies might work here because the total market capitalizations of a lot of the smaller E&P companies have now fallen below the level at which they are of interest to the hedge funds and larger market players. My interest in particular is in E&P companies with market capitalizations below $300 million. There is little to no motivation for equity analysts who do not want their portfolio holdings to pass the 10% mark to bother about companies of this kind. As a quick refresher, recall that nano cap stocks have market caps below $50 million, microcap stocks have market caps between $50 million and $300 million, small-cap stocks have market caps up to $2 billion, mid-cap stocks have market caps between $2 billion and $10 billion, and large-cap stocks have market caps above $10 billion. Few analysts cover nano- and micro-cap stocks under $300 million.

The small-cap premium that I am trying to capitalize on by means of this E&P basket-style investment is the idea that stocks with smaller market capitalizations in fact over time tend to earn higher returns than stocks with larger market capitalizations. This idea originates in part from the fact that small-cap stocks are less extensively covered by analysts and news media outlets. In part, it originates from the notion that companies of smaller size have more room to grow than their larger-sized counterparts, since they (presumably) have not yet saturated their target markets with their product offerings. There have also in fact been studies, dating back to the 1970s, that have demonstrated that companies that are smaller tend to earn higher returns (up to 4% or so) than companies that are larger. Smaller cap companies are also likely to get oversold in deep-value bear markets.

Amid all of the fear and panic in this sector, fewer valuation discrepancy advantages are likely to be found in mid-cap companies, and fewer still among large-cap integrated names like Chevron, Exxon Mobil, and BP. But investors who are less daring could certainly join my basket-style strategy with a strategy of going long these larger energy names as a safety mechanism. If they choose to do so, I recommend going long BP, where the oil sector panic seems to have been priced in, and not CVX, where the share price has actually held steady and at times increased (!) over the last few months.

In short, the strategy makes sense because of the possibility of inefficiency in the current market's collective psychology. Equity analysts cover a company up until it falls below a certain threshold, then they drop it.

Finally, notice that I am only considering this strategy for American E&P names - mostly the players in the tight oil and gas market. International names in my view are much more speculative in this pricing environment because of the capricious activities of the governments of the countries in which they are located (i.e. Venezuela, Argentina, Brazil). For instance, one company which I will not be considering for this portfolio is Petrobras (NYSE:PBR). For one, the company is much too large in terms of market capitalization to be a candidate player in a portfolio of this kind (i.e. one based on the idea that there might be inefficiencies in the micro-cap E&P space). The market is much less likely to get PBR wrong in the current pricing environment than, say, to get MEMP or BBG or GTE wrong simply because of the sheer number of analysts covering it. But for another reason, some of the most dangerous influences on the welfare of distressed energy companies right now are the laws and policies of the countries in which such companies are incorporated. These laws impact not only the international companies' production of oil and gas, but also its consumption and distribution.

Disclosure: I am/we are long CHK, XOM, CVX, BP, CLR, DUK, WLL, BBG, AXAS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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