The Oasis Petroleum (NYSE:OAS) bond route is on - just as expected. But the good news is, it should only just now be getting started- leaving plenty of room for opportunistic short sellers to take advantage of downward pricing pressure and leaving time for those long exposure to sell exposure down. Even if you're not in the business of "bond trading", meaning even if you're exposed to the Oasis debt stack in a yield-capture priority and are blind to the actual market pricing of the bonds, selling the bonds here (in the mid-$80's for most of the debt stack) and buying back at deep discounts will do well for blending carrying-yield higher. Again, these are concepts I presented in an initiation note back in mid-May. I reiterate these thoughts today and update my thesis prior to Oasis reporting Q2/2016 results.
Updating the Thesis…
Originally, in my initiation note, I thought the Oasis debt stack had exposure to three primary risks: commodity pricing mean reversion (lower to mid-$20's/mid-$30's WTI pricing) - which would change the credit outlook for Oasis (in that it would make higher in visibility the next risks listed), "priming risk" [or the risk that Oasis would issue more debt and/or senior debt (via its First Lien - or its revolver)], and potential downgrade risk driven by what would be a higher visibility into Oasis funding its ambitious maturation plans via increased leverage. As it turns out, all of these factors have come into play since publishing my initiation note. Again, the point of this note is to reiterate my original thesis but also to note that the bond pricing degradation detailed above(in the data-visual) should only accelerate from here forward. That matters. This trade is very, very young and still very, very viable.
With oil pricing being the primary driver of financials at Oasis, and with oil pricing having seen an accelerated collapse in pricing T30D [driven largely, in the opinion of this author, by the resetting of "temporary factors" (mild geopolitical risks, mild supply chain disruptions internationally, a fleeting sentiment shift on a global basis towards a supply balance, etc.)], commodity pricing mean reversion should continue to be the primary driver to downward pressure on the debt stack. This might take place with increased delta after Oasis reports Q2/2016 earnings. I'll be very closely watching both average sales prices realized without derivative settlements and average sales prices realized with derivative settlements.
Yes, I'll be watching in that pricing very clearly matters to the underlying structural integrity of the current debt stack at Oasis (SEE: priming risk noted above) - but also because Oasis stands a reasonable PV-10 markdown risk come 10-K reporting time in just a few quarters (as noted and expanded on within my initiation note). While this was a "tertiary risk" noted at initiation, certainly not a "core risk" in that the PV-10 calculation for oil and gas firms is highly subjective, this is a risk that matters and one that we'll have higher visibility into post-Q2/2016 reporting. With seemingly no global oil supply balance coming soon (in fact, US oil rig counts have risen for five consecutive weeks) commodity pricing pressure should continue to be the primary downside risk driver for Oasis bond pricing.
Again though, lack of commodity driven upside to economics (or reiterating that oil pricing shouldn't be birthing a young bull anytime soon) matters most in that it drives the risk most directly impacting bond pricing outputs at Oasis - priming risk. If Oasis can't "self-fund" its ambitious maturation plans via free cash flow (PLEASE make note that Oasis defines its own, non-GAAP version of free cash flow in filings and in investor presentations which is not in any way comparable to the standard GAAP definition), it will have to do this via equity issuance, debt issuance, and/or drawing down in increments on its revolver. I've listed these in my expectation of least likely to mostly likely. To be perfectly clear, only equity issuance wouldn't be harmful to bond pricing. While none of this should be "breaking news" to those familiar with debt trading/credit-risk management I did find this worth reiterating.
With Oasis' equity now pricing on relatively close to the 52-week lows (OAS has retraced from T90D highs of ~$11.00 to just under $7.00 as of last close - OAS also trades with significant downside elasticity) I'm doubtful it would choose to fund any meaningful expenditures via this option. Besides being punitively dilutive this wouldn't be the most efficient route of raising funding at this point (not even close). And while Oasis could presumably go out and market new Notes, as mentioned at initiation, 1) there is a fairly time consuming process to marketing new Notes, 2) the new Notes likely would come at a greater than 700 bps cost (Oasis' current cost of capital is 688 bps), 3) the new Notes likely would come with much "tighter" or restrictive covenant scheduling (this would limit the currently open architecture ability for Oasis to operate), and 4) there is an underlying cost (likely in the millions of dollars) to execute this transaction through an investment bank. All of these, in the opinion of this author, also call into question the efficiency of this fund raising route. In the opinion of this author, far and away the most efficient route for Oasis to fund its ambitious plans is via its existing, already in place, low cost, not at all restrictive revolver.
Oasis' revolver is undrawn - leaving plenty of room and visibility for access. Oasis' revolver is huge - $1.1 billion in depth. And maybe most importantly, Oasis' revolver isn't covenant restrictive - the only financial covenant on the revolver is an interest coverage covenant of 2.5X (at last reporting Oasis was printing a 4.7X trailing twelve months' interest coverage multiple). Finally, Oasis' revolver is inexpensive - pricing at just LIBOR plus 150 bps. I think any reasonable person reading this note would agree that (even when excluding fees associated with executing the transaction) there's no way Oasis could go out and raise additional debt at that cost. Definitively, it just makes most sense for Oasis to draw down on its revolver.
This means the existing Oasis debt stack - already, I'm sure, feeling the pressure of some priming risk - will be superbly primed. This plus commodity pricing pressure essentially ensuring priming will take place for a time into the future should allow the entire existing debt stack to price into the $40-$50 range (top and bottom of range determined by additional, duration-based risk; net-range logic is explained in detail within my initiation note). This implies another 50% downside risk for the entire debt stack. Again, we're already seeing this to the tune of 3%-9% losses for the stack since mid-May:
I think the logic and the data-based case here is irrefutable. But, if this case so far (when coupled with my initiation note from mid-May) isn't compelling enough - there's also the final mixer in this three mix risk-cocktail. Oasis' downgrade risk is growing substantially (via Kamakura Corporation - a risk management and consulting firm):
The top data-visual is the original data called out in my initiation note. Within this note I stated, "I also think, despite the data not agreeing with me (just yet), that if Oasis issues more debt via Notes or takes on substantially more debt via its revolver, the E&P's bonds will be subject to a ratings downgrade on the increased risk". Now, with that revolver driven risk being more visible and with it seemingly being longer in duration (from a visibility standpoint) - Oasis' upgrade "risk" has decreased a whopping 1500 bps. The bottom data-visual reflects updated upgrade risk as well as downgrade risk; Oasis' downgrade risk has doubled. Put simply, the visibility into a credit downgrade and a specific downgrade of the existing debt stack is increasing at what should be alarming rates. To be clear, any credit downgrade (at all but specifically tethered to the existing debt stack) would be extremely punitive to bond pricing.
Updating Summary Recommendations…
My recommendation would be to sell first/target for short-selling first/remain short (from the mid-May initiation) the longest durations first, the shortest duration bonds last. This was my initial recommendation and it has played out in-line to expectation (as is illustrated via the summary data-visual at the introduction of this note). However, at some point of intercept the velocity of pricing degradation will slow on the long bond and be surpassed by the velocity of the short bond (simply the law of large and small numbers; speaking specifically of total dollar volume being sold down per bond). Make sure, if shorting one of the bonds OR shorting the debt stack as a blend, to watch this dynamic and to risk manage this dynamic in real-time; otherwise you'll leave some efficiency on the table.
Regarding when to add these issues to a long portfolio (again I believe these issues to ultimately be safe; at least as of the writing of this note) - I would recommend beginning to shop between $40-$50. The variance of pricing will be determined by duration (i.e. shorter duration bonds will be a nice value at the top of that range while longer duration bonds will be a nice value at the bottom of that range). Doing so should allow for a nice, high-yielding, relatively low-stress (for yield being captured) bond strategy.
Good luck, everybody (and stay tuned for updates).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.