If one had told us a year ago that for 2015 the best risk adjusted trade would be to go long 10 year Treasurys, locking in a 2.25% annual return, we would probably have asked them if they also enjoyed Wednesday night church bingo. Yet, with the S&P 500 on track for a flat performance in 2015 (up 2.3% year-to-date, including dividends), and high yield bonds on track for a negative 3.5% total return year, maybe it’s time to revisit our entertainment, and possibly investment, priorities. For 2016, we expect the restructuring of a large number of energy related balance sheets, as oil refuses to trade up to anywhere close resembling triple digits and likely to stay below $50, with the bloodletting hitting spread-hungry investment portfolios. Nonetheless, while we do believe that the pain felt in the energy patch will be material and will likely reshape the oil and gas exploration landscape, we do not expect a significant contagion to the rest of the financial markets nor the economy. As a result, we expect the equity market to withstand the projected two to four interest rate hikes by the Federal Reserve, albeit all within a framework of modest continued economic growth. To summarize, we expect an equity market return in the mid-single digits for 2015, setting the stage once again for security selection to precede asset allocation as a means of generating excess returns.
“I have a competition in me. I want no one else to succeed.” Daniel Plainview (Daniel Day-Lewis) in the 2007 movie There Will Be Blood.
US crude oil production has nearly doubled in the last five years as improvements in oil and gas exploration and production over the last couple of decades were matched with Federal Reserve-induced cheap capital. At the same time, OPEC’s market share of global production has dropped to less than 35%, dulling the price control power of the cartel. This trifecta of technology improvement, cheap capital, and loss of oligopolistic power, has resulted in a precipitous decline in the price of oil (and natural gas), as the creative destruction of competition has motivated producers to be price takers, as they seek to maximize their own gross profit, leveraging their lower marginal costs of production.
The increase in US production during the last 5 years, together with more tempered consumption growth globally, eventually started taking its toll on the market clearing price, with oil falling off a cliff in late 2014. What appeared to have been stabilization for most of 2015 proved to have been short-lived, with oil resuming its downward trend as the year progressed.
According to industry sources, approximately 20% of US production in 2015 was hedged, and these hedges are expected to be rolling off over the next few months. Looking at the average spot WTI crude price over the five years preceding 2015 it is clear that the 2015 level represents a material event for the sector. Given that the current spot level of around $38 is once again materially below 2015’s average, were this to hold in 2016, the oil patch carnage is likely to continue unabated.
“I have two others drilling and I have sixteen producing at Antelope; so, ladies and gentlemen, if I say I'm an oil man, you will agree. Now, you have a great chance here, but bear in mind, you can lose it all if you're not careful.” Daniel Plainview (Daniel Day-Lewis) in the 2007 movie There Will Be Blood.
As energy prices have collapsed, so have equity and debt prices of energy companies. Using the Vanguard Energy ETF (Ticker: VDE) as a proxy, energy stocks are on track to post a negative 25% return in 2015. Bond prices of energy high yield issuers have also cratered, with the option adjusted spread (OAS) of the energy index (Bloomberg Ticker: USOHHYEN) widening from 930 bps at the beginning of year to almost 1390 currently).
We expect the impact of lower energy prices on energy companies’ financial asset prices to lead to significant restructuring of energy balance sheets over the next 12 months. We believe many of the poorly capitalized companies will be unable to avoid bankruptcy as cash flows are unable to sustain maintenance capital spending as well as meet debt service requirements.
In order to identify which energy companies are at a significant restructuring risk, and which ones have balance sheets built to withstand the times, we looked at the energy names under our coverage universe to gauge how much room they may have to take on additional or refinance debt. We looked at two straightforward metrics: i) total debt (net of cash) as a percentage of total enterprise value (EV), and ii) bank debt / market value of equity. The first metric helps establish how flexible a company may be to raise additional equity capital to delever or alternatively have room to issue more debt, even under current conditions. The second metric seeks to measure balance sheet stress due to bank debt outstanding, as it is the banks that will be at the driver’s seat on how much flexibility a company may have.
In the following chart we rank energy sector companies by sub-sector (oil and gas producers, oil and gas services companies, and pipelines) by decreasing debt to enterprise value. The beige colored area includes companies with at least a 50% debt ratio, representing the more concerning balance sheets. The light blue colored areas represent companies with less than 25% debt/EV, representing the least levered, and thus the most stressabsorbing balance sheets for in each subsector. Following this chart, we have one more that drills down to the bank debt level, and ranks companies in decreasing order on the ratio of bank debt outstanding relative to equity market value (MV). Similarly, we highlight the problem balance sheets with beige (bank debt/MV greater than 100%), and the non-problematic with bank debt/MV (less than 10%).
The real trouble we believe will be felt by companies that measure poorly on both of these metrics, as they are likely to have limited sources of unencumbered assets or capital to navigate through the current pricing environment. Companies that only look weak on one of these metrics may have more flexibility. For example, Chesapeake Energy has net debt to enterprise value above 50% (at 62%), yet, has no bank debt outstanding. The company took advantage of this fact, coming to the market with an offer to swap near-maturity unsecured bonds for fewer, structurally senior, and longer dated notes. In a single transaction, Chesapeake is essentially taking advantage of its low level of secured debt and the selloff of its existing notes, to extend maturities and reduce debt principal. For companies that already have secured debt of material amounts, this flexibility may not be available. The table below shows the energy companies we track that have both too much debt and a heavy load of bank debt – investor beware.
For those investors that have flocked to the energy sector for the dividend yields, the market correction has been particularly painful, as companies have started to slash their payouts as a result of the depressed energy prices. On aggregate, compared to peak 2014 dividend levels, we expect energy companies to slash dividends as much as 80%-90% on aggregate, unless a material and lasting reversal of energy prices occurs early in 2016.
“New roads, agriculture, employment, education - these are just a few of the things we can offer you, and I assure you, ladies and gentlemen, that if we do find oil here - and I think there's a very good chance that we will - this community of yours will not only survive, it will flourish.” Daniel Plainview (Daniel Day-Lewis) in the 2007 movie There Will Be Blood.
As capital investment drove the increases in US energy production over the last seven years, leading to a near doubling of domestic oil output, this investment also benefited the surrounding local economies, and by extension the US economy at large. Now that the oil patch is has become a source of wealth destruction, will the same contagion lead to similar pain to be felt by the greater economy? The primary transfer mechanism of contagion in a well-developed economy is most often credit. Or more specifically, the impact of credit stress in one sector of the economy infecting other leveraged sectors as risk is repriced more generally. To study the contagion of energy to the greater economy, we use the high yield market as a proxy. The high yield market, similar to the equity market, had a great bull market run from the depths of the great recession (see chart), but unlike equities, this run turned negative in late 2014.
The energy sector of the high yield market was a prolific issuer over the last few years, most often representing the single largest issuance of high yield debt, and allowing the sector to exceed 20% of the high yield index’s outstanding bonds. But, as the price of oil started dropping in the second half of 2014, it didn’t take long for the bonds of high yield energy issuers to start feeling the pain. A 500 bps widening in energy high yield started impacting the entire high yield market, a trend that continued and even accelerated in 2015.
In order to address whether the contagion from the energy sector’s meltdown will have a lasting effect on the broader high yield market, and by extension to the equity market, and possibly to the US economy, we remind readers of a similar “single sector meltdown” that occurred in early 2000 to 2002, namely the dot.com bust and its impact on the high flying communications sector which had been a prolific high yield issuer, as it too accounted for the single largest contributor to high yield issuance through the late 1990s. Including media, the communications sector amounted for as much as 35% of the high yield index by the turn of the century. As can be seen in the following chart, the telecom sector melted in the 2000 to 2002 timeframe with sector bond yields exceeding 20% and staying at these elevated levels for about a year after that, before there was any recovery.
The telecom sector’s demise in the early 2000s pushed overall default rates in high yield well above their historic 4% to 4.2% average to more than 10% at its peak by the end of 2002. As the next two charts show, once we decompose the 10% plus all industry default rate, we see that it was the telecom sector’s 30% plus default rate that drove the majority of this increase. We estimate that excluding telecom, high yield defaults probably never exceeded 6.5% to 7.0% during this period.
We believe the important takeaways from this period are several: i) the contagion impact from the telecom sector’s meltdown on the trading levels of the rest of the high yield market was real, ii) it lasted for a couple of years, not quarters, iii) while default rates for telecom were massive, overall high yield defaults were not, iv) once default rates peaked, it took a few quarters for the high yield market to start its next bull run. In other words, although the impact was real, meaningful and lasting, for those patient enough, a single sector’s demise proved to mostly have been a great buying opportunity for the rest of the high yield market. We believe the current demise of the energy sector may just prove as much for the high yield market this time around.
Where does the equity market go from here?
Since the post-financial crisis bottom in early 2009, the equity market has about tripled, with the S&P 500 generating a more than 20% annual return. As can be seen from the following chart, during this time S&P 500 EPS have staged an impressive bounce back from their 2008 low.
In order to appreciate the equity market’s performance, it is useful to decompose its appreciation (before dividends) between the earnings (EPS) growth the change of the earnings multiple (P/E). The following chart does just that. For each period we show the annual growth (contraction) in EPS and the P/E multiple expansion (contraction) in percentage terms. The net effect of these two values is the appreciation (depreciation) of the S&P 500 during the period (before dividends).
As can be seen on the chart, since the financial crisis, starting in 2009, the S&P 500 in on track to experience its seventh consecutive year of EPS growth. Further aiding stock market performance, since 2012 the S&P has also benefited from a P/E multiple expansion as well as the P/E expanded from a low of 13.4x in 2011 to 17.5x this year. 2015’s roughly flat return was composed of roughly offsetting amounts of EPS growth, and multiple contraction (the blue and burgundy bars are about equal for 2015 in the chart).
For 2016, S&P 500 EPS are expected to grow to $128 from $117.50 expected for 2015, a 9% increase (see the report’s Appendix for the details). Were the market to maintain its 2015 P/E in 2016, this 9% earnings upside, when added to a roughly 2.1% current dividend yield would put the S&P 500’s total return at around 11%, slightly above its longer term average return. Our suspicion is that, given where we are in the earnings cycle, the end of quantitative easing (QE), the expected 2-4 increases in short term rates, the dislocation of emerging markets from the rally in the US dollar, as well as the previously discussed expected lingering restructuring in the energy sector, the equity market may have to give some more multiple back in 2016. With that in mind, we believe a mid-single digit equity market return is more likely than a double digit one. We do believe by the way, that a meaningfully negative total return year for equities is unlikely, as we believe the risk to a significant earnings disappointment or material multiple contraction in absence of a domestic economic contraction is equally unlikely. For those readers that demand a single point estimate, we suggest a 5% total return, expecting a modest continued multiple contraction, and some buffer for reduced earnings expectations as 2016 progresses.
As always, we thank you for your interest and support, and welcome all questions and suggestions.
Dimitri Triantafyllides, CFA
Sixty Guilders Research, LLC
This report is for your information only and is not an offer to sell or a recommendation to buy the securities or instruments named or described in this report. Additional information is available upon request. The information in this report has been obtained or derived from sources believed by Sixty Guilders Research, LLC (Sixty Guilders) to be reliable, but Sixty Guilders does not represent that this information is accurate or complete. Any opinions or estimates contained in this report are current as of the date of the report and are subject to change without notice. Copyright © 2015 Sixty Guilders Research, LLC.
Conflicts of Interest. Sixty Guilders, its employees and its affiliates may from time to time hold securities mentioned in this report, either long or short, whether relying or not on information provided in this report.
Sources of Information. The information in this report has been obtained or derived from sources believed by Sixty Guilders to be reliable, but Sixty Guilders does not represent that this information is accurate or complete. Estimates for revenue and cash flow (EBITDA) are derived from street expectations as of the date of publication, therefore changes following the publication of the report are not reflected in the report. Other estimates in the report are provided by Sixty Guilders and may similarly be changed following the publication of the report.
Ratings. Sixty Guilders does not provide buy, hold or sell recommendations on the debt and equity securities profiled in its reports. Instead, Sixty Guilders force-ranks securities under coverage on a percentile scale, ranging from 100% (highest possible percentile) to 0% (lowest possible percentile). As a result, Sixty Guilders’s rankings are evenly distributed across the percentile spectrum of 100% to 0%. In its reports, Sixty Guilders discloses rankings for a company’s equity appeal and credit quality in 10 percentile increments rounded to the lowest 10 percentile increment. This format is also followed for a company’s peer group (“industry sector”). Industry sector rankings similarly rank sector fundamentals against the broader Sixty Guilders coverage index. In order to preserve the ranking relevance on our index data, company credit and equity percentile rankings are not rounded when displayed on the index. Furthermore, rankings on company reports are only current as of the publication date of a report, and may change as a company’s credit or equity relative appeal may improve or deteriorate following the publication of a report. Since our index data are updated daily, credit and equity rankings on the index are more current than those published in reports whose publication date may have been several days or weeks prior to the most recent current ratings.
Oil & Gas Industry Sector
Oil & Gas sector companies explore for, develop produce and transport crude oil and natural gas (upstream) and/or refine, market, and distribute petroleum, petrochemicals, and other distillates and derivative products (downstream). Demand for crude oil and natural gas is extremely sensitive to economic conditions as well as fluctuations in currencies and global inflation trends.
Companies included: Alon Usa Energy Inc, Apache Corp, Anadarko Petroleum Corp, Approach Resources Inc, ARC Resources Ltd, Atwood Oceanics Inc, Breitburn Energy Partners LP, Bill Barrett Corp, BP PLC, Baytex Energy Corp, Chesapeake Energy Corp, Calumet Specialty Products, Continental Resources Inc, Canadian Natural Resources, Cabot Oil & Gas Corp, ConocoPhillips, Canadian Oil Sands Ltd, California Resources Corp, Comstock Resources Inc, Carrizo Oil & Gas Inc, Cenovus Energy Inc, CVR Energy Inc, Chevron Corp, Clayton Williams Energy Inc, Concho Resources Inc, Denbury Resources Inc, Diamond Offshore Drilling, Devon Energy Corporation, Encana Corp, Energen Corporatio, EOG Resources Inc, EQT Corp, Eagle Rock Energy Partners, Ensco PLC, EV Energy Partners LP, Energy XXI Bermuda, Total SA, Goodrich Petroleum Corp, Gulfport Energy Corp, Hess Corp, HollyFrontier Corp, Helmerich & Payne, Husky Energy Inc, Linn Energy LLC-Units, Laredo Petroleum Inc, MEG Energy Corp, Marathon Petroleum Corp, Marathon Oil Corp, Murphy Oil Corp, Noble Energy Inc, Nabors Industries Ltd, Noble Corp, Newfield Exploration Co, Oasis Petroleum Inc, Occidental Petroleum Corp, Precision Drilling Corp, PDC Energy Inc, Petroleo Brasileiro SA, Parker Drilling Co, PetroQuest Energy Inc, Phillips 66, Penn Virginia Corp, Pioneer Natural Resources Co, QEP Resources Inc, Rowan Companies PLC, Transocean Ltd, Range Resources Corp, SandRidge Energy Inc, Stone Energy Corp, SM Energy Co, Suburban Propane Partners LP, Seventy Seven Energy Inc, Suncor Energy Inc, Southwestern Energy Co, Tesoro Corp, Unit Corp, Valero Energy Corp, Vanguard Natural Resources, Whiting Petroleum Corp, Western Refining Inc, WPX Energy Inc, W&T Offshore Inc, EXCO Resources Inc, Cimarex Energy Co, Exxon Mobil Corp.
Oil & Gas Services sector
Oil & Gas service companies provide ancillary services to the oil and gas exploration, storage, transportation and distribution companies. Their services vary from subcontracting functions such as drilling, surveying, transportation, to communications, staffing and consulting.
Companies included: AmeriGas Partners LP, Basic Energy Services Inc, Baker Hughes Inc, Bristow Group Inc, Cameron International Corp, Calfrac Well Services Ltd, CGG, Seacor Holdings Inc, FMC Technologies Inc, Halliburton Co, Helix Energy Solutions Group, Key Energy Services Inc, Nuverra Environmental Soluti, National Oilwell Varco Inc, Oil States International Inc, Pioneer Energy Services Corp, Petroleum Geo-Services, PHI IncVoting, RPC Inc, Schlumberger Ltd, Superior Energy Services Inc, Thermon Group Holdings Inc, Weatherford Intl Ltd.
Pipeline companies own and operate regional networks of pipeline for the transportation of refined petroleum products or natural gas primarily downstream to distributors and retailers. The sector includes gas and oil storage companies as well.
Companies included: Buckeye Partners LP, Boardwalk Pipeline Partners, Cheniere Energy Partners LP, DCP Midstream Partners LP, Enbridge Energy Partners LP, Enbridge Inc, EnLink Midstream Partners LP, Enterprise Products Partners, Energy Transfer Equity LP, Energy Transfer Partners LP, Genesis Energy LP, Holly Energy Partners LP, Kinder Morgan Inc, Magellan Midstream Partners, MarkWest Energy Partners LP, Targa Resources Partners LP, Niska Gas Storage Partners-U, NuStar Energy LP, ONEOK Inc, ONEOK Partners LP, Plains All Amer Pipeline LP, Pembina Pipeline Corp, Spectra Energy Corp, SemGroup Corp, Spectra Energy Partners LP, Sunoco Logistics Partners LP, TC Pipelines LP, Tesoro Logistics LP, TransCanada Corp, Western Gas Partners LP, Williams Cos Inc, Williams Partners LP.