The Selective Energy Opportunity

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Includes: HYLD
by: AdvisorShares

Summary

After working to sizably cut our energy allocation in early 2015 as we expected the volatility in oil to continue, we are now selectively adding a few energy names.

The continued issues surrounding E&Ps have created opportunities in other sub-segments within energy.

The opportunities we are primarily focused on relate to the contagion trade.

By Tim Gramatovich, DFA, CIO and Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSEARCA:HYLD)

After working to sizably cut our energy allocation in early 2015 as we expected the volatility in oil to continue, we are now selectively adding a few energy names to our portfolio. Since we have been clanging gongs for a long period of time on the avoidance of high yield bonds financed by U.S. exploration and production (E&P) companies operating in shale basins, has anything changed now that many of these bond prices have collapsed? Not really. While we have looked at survivors in the space, it remains a difficult business model to finance with debt and we are already starting to see a wave of defaults in this energy sub-segment, and expect we will see many more. Ironically, after this restructuring cycle, many of these companies could be financially viable as they have no debt costs to service, which we believe is one of the reasons U.S. production will not collapse going forward. From the work we have done, $40-$45 oil and limited debt to service could allow these companies to exist even with the drilling treadmill they are on, as costs have come down and efficiencies have improved.

The continued issues surrounding E&Ps have created opportunities in other sub-segments within energy. The opportunities we are primarily focused on relate to the contagion trade. By this we mean connected businesses that have been sold down well below what we feel is justified but have different business models. Midstreamers including pipelines and downstream (refineries)-the companies that process, refine, store, and transport the oil and gas produced by the E&P companies and other chemicals-are examples where we see potential value. We don't see huge cash bleeds or defaults on the horizon in many of these connected businesses, and we see it as a way to benefit from potential upside in oil without having direct exposure to prices. Many of the midstream players are master limited partnerships (MLPS), which may have to cut or eliminate their dividends. But by doing so, they are conserving cash to the benefit of servicing their debt. We also see a likely consolidation cycle coming where investment grade buyers who have a very low cost of capital acquire these high yield companies, allowing them to refinance the debt, capturing massive interest cost savings, and buy this infrastructure cheaper than they can build it, which presents upside for existing debtholders.

Chapter 11 is currently being used as a capital markets tool to reduce debt levels-even for companies that might be able to pull through this current oil pricing environment with existing liquidity, many are instead pre-emptively filing bankruptcy to reduce debt levels. We see this is a dangerous environment for many bondholders in shale E&P and associated service providers. 90% of defaults so far this year are commodity related.1 Energy is over 13% of the high yield market2 and we do expect defaults to remain concentrated in this sector. However avoiding energy entirely isn't the answer.

The current opportunity in selective credits associated with the energy sector actually rhymes with a trade we executed on back in 2002-2003 involving the telecom, media and technology ("TMT") meltdown. The victims back then weren't E&P companies but the Competitive Local Exchange Carriers ("CLECs"). When they melted down, they dragged down the whole telecom sector, just as we see today. This included cell tower companies and rural cellular companies, which is where we saw opportunities and focused our commitments. Those turned out well, while the CLECs themselves basically vaporized. The "obvious" bargain generally turns out to be the value trap. But then, as we see now, when you see an entire sector/sectors take a hit, there is generally attractive opportunity to be had somewhere in the space and as a value-based investor we feel it is prudent to look for where that value may be.

While in many cases debt will be wiped out and/or equitized, these E&P companies are not going away and we don't expect a collapse in U.S. production. These companies will restructure, eliminate debt, and re-emerge from bankruptcy, all the while continuing to produce product to be processed, refined, and transported. We spoke a few weeks ago about a new high yield index-based exchange traded fund that excludes energy. Yes, this may help investors avoid the larger concentration of defaults, but it also removes some of the opportunities in the space-yet again another example of why we see active management as so essential in this asset class. As we conduct our own fundamental analysis and work to gain a true understanding of the business and industry dynamics, we have always been value-based investors, often thematic investors, looking for those companies that we see as undervalued, producing what we see as a healthy yield and capital gains potential for our investors.

1 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. "Credit Strategy Weekly Update," J.P. Morgan North American High Yield Research, April 29, 2016, p. 55.
2 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. "Credit Strategy Weekly Update," J.P. Morgan North American High Yield Research, April 29, 2016, p. 4.

Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. Information on this website is for informational purposes only. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risk and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: AdvisorShares is an SEC registered RIA, which advises to actively managed exchange traded funds (Active ETFs). This article was written by Tim Gramatovich, DFA, CIO and Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus, the portfolio manager of the AdvisorShares Peritus High Yield ETF (HYLD). We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article. This information should not be taken as a solicitation to buy or sell any securities, including AdvisorShares Active ETFs, this information is provided for educational purposes only.

Additional disclosure: To the extent that this content includes references to securities, those references do not constitute an offer or solicitation to buy, sell or hold such security. AdvisorShares is a sponsor of actively managed exchange-traded funds (ETFs) and holds positions in all of its ETFs. This document should not be considered investment advice and the information contain within should not be relied upon in assessing whether or not to invest in any products mentioned. Investment in securities carries a high degree of risk which may result in investors losing all of their invested capital. Please keep in mind that a company’s past financial performance, including the performance of its share price, does not guarantee future results. To learn more about the risks with actively managed ETFs visit our website AdvisorShares.com.