The oil shake-out is on but rather then swerve the industry like a bad smell, one portfolio manager sees opportunities in its “cyclical bottoming”.
Geoff Castle, who manages the Pender Corporate Bond Fund at Penderfund Capital Management, acknowledged there are multiple problems affecting the industry and its long-term outlook.
He highlighted the oil business’ major contribution to climate change and the likelihood of its size being diminished as cleaner, less-wasteful substitutes come to the fore.
That said, he also argued that so much of our lives depend on the use of oil or petroleum-derived products, be it through jet fuel and computer monitors, for example. The conclusion is that, while moderating, the demand for oil is not plummeting.
He said: “Beyond the overarching trend, we also observe the oil market as a typical commodity market with periodic booms and busts. The most recent of such booms, which culminated in $100 per barrel pricing at West Texas in 2013 and 2014, has long since reverted into a gruelling challenge to corporate survival.
“Accounting smoke-and-mirrors games may have propped up belief in the apparent profitability of some marginal producers longer than otherwise might have been the case. But, ultimately, it has become clear that oil priced in the $50s per barrel cannot be produced profitably by entities with all-in-sustaining costs in the $70s or $80s.
“The shake-out is on. And, one by one, the overleveraged and under-profitable players are shaking out. Producers such as Sanchez, Jones Energy and Halcon have been hitting the wall while suppliers to the industry like Weatherford and PHI Inc. have also been pushed to restructure.”
Castle said that such a cloud over the industry and with arguably weak longer-term fundamentals, it is tempting to give the whole sector a miss, like Penderfund did for most of 2017 and 2018 with barely 2% oil credit weight.
However, in 2019 it has found a few areas where he believes a credit investor can profit from a cyclical bottoming.
He explained: “We look to invest in places where capital is scarce, acting on the belief that where capital is scarce it tends to earn higher returns.
“One of the areas we like is small, cash-profitable producers. Perhaps because so many oil juniors are cash-burning wrecks, some free cash generating smaller producers like W&T Offshore and recently added Surge Energy have been shunned.
“In these names we consider ourselves to be poised to earn yields of 8-10% with annual default probabilities of less than 1%. We also own 1st lien debt of FTSI Inc., a hydraulics-oriented oilfield supplier, where we see similarly attractive risk-reward characteristics.
“We include a position in the distressed debt of PHI Inc., the offshore helicopter operator, where we are hopeful for a good result driven by industry consolidation. And in the downstream business, we consider the near term 2021 and 2022 maturities of Parkland Fuels to be relatively safe opportunities to pick up yield points without committing to the industry for an extended term.”
Castle said the fund is still less than 10% invested in the sector and believes that, because of the lower-priced nature of many of these credits, they weigh slightly more in terms of the fund’s prospective returns than the headline weight suggests.
He added: “At a point we believe to be near to a cyclical low for producers, we believe these credits can deliver strong risk-adjusted returns.”
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