Fund managers take second look at indebted drillers

Last year, Toronto-based Sprott Asset Management's energy fund sometimes had only 30 percent of its cash invested, as oil and gas stocks fell fast and furious.

That's changed.

Heading into this year, the fund was effectively fully invested, portfolio manager Eric Nuttall said.

"I really do think the risk has swung from being invested in energy stocks to not being invested in energy stocks," he told CNBC's "Squawk on the Street" just before the new year.

"The best risk-to-reward opportunities are buying those names that are today perceived as being over-leveraged. As oil recovers, the perception will swing from the balance sheet problems to the mispricing." -Eric Nuttall, portfolio manager, Sprott Asset Management

To be sure, the oil exploration and production sector, facing high levels of debt and falling revenue, is a risky one. But many financial professionals are buying energy companies — if those outfits have relatively strong balance sheets. With stocks trading at huge discounts from their peaks, and oil prices expected to rebound at some point this year, some investors and money managers are beginning to take a second look at companies with high debt.

There are two questions those managers are asking first and foremost, said Alison Deans, consultant at AA Deans Advisors and a CNBC contributor: Can the companies generate enough cash to cover the cost of operations and interest payments? And what are the terms of their debt?

Some energy-sector loans will not come due for years — after an anticipated oil price recovery — while others include covenants that could turn the screws on already battered balance sheets in the nearer term.

Nuttall said he is actively avoiding safe haven investments that others have championed, including the big oil majors and downstream refiners, whose profits and stock prices have held up better than upstream exploration and production companies.

Instead, he is focusing on Canadian energy stocks that fell 80 percent in 2015, which he said can easily double if his prediction that oil will hit $50 per barrel by the third quarter is correct. Those investments include Baytex Energy, whose debt levels look high when oil in the $30s or below, but whose loans do not come due until 2021, he said.

"The best risk-to-reward opportunities are buying those names that are today perceived as being overleveraged," he said. "As oil recovers, the perception will swing from the balance sheet problems to the mispricing."

To be sure, the U.S. Energy Information Administration projects that U.S. crude prices will average $38.54 per barrel in 2016, while Brent will be slightly higher at $40.15.

'Patience is critical'

Investment firm Southeastern Asset Management recently said its energy holdings can have a positive impact on its 2016 performance even without an energy price rebound because they have fallen so far. Southeastern acknowledged that some investors believe its primary energy holdings — Cheseapeake Energy and Consol Energy — could see their cash flow turn negative and their assets become worthless if oil and gas prices stay lower for longer.

"We don't know when supply and demand will rebalance and adjust prices, and thus far, our energy assumptions have been wrong. Patience is critical because both energy prices, along with the stocks of Chesapeake and Consol, can turn rapidly," Southeastern said in a shareholder letter it released Dec. 31, referring to its two primary energy holdings.

Chesapeake's debt is about eight times earnings before certain expenses, based on a 12-month average price of $46, according to a calculation by investment bank Tudor, Pickering, Holt & Co. That is well above the level with which many investors are comfortable.


Derek Rollingson, manager of the four-star rated by Morningstar Icon energy fund, said he is focusing on energy storage and transportation holdings, whose revenues are influenced less by the rise and fall of crude than are drillers', but whose shares have been beaten up nevertheless.

Icon sees about $1.26 in value for every dollar invested in these midstream players, based on forward-looking earnings and its discount rate. That's slightly higher than the $1.08 valuation for every dollar investment it sees in its exploration and production holdings.

The firm has halved the number of E&P stocks it holds to 15 names, because the probability of default for a number of its previous holdings exceeded its "hurdle rate," or the minimum rate of return it needs to justify the risk of holding an investment.

But with energy shares near rock bottom, the firm is hunting for value once again.

"We're getting to the point where we're starting to see a little bit more value in the beat-up names because the price decline is starting to exceed that hurdle rate," he said. "So we're definitely keeping a close eye on it and looking for opportunities to re-establish positions."

Close, but too early

It still feels too early to buy into some heavily indebted companies, said Deans of AA Deans Advisors. First, Deans said she needs to see a string of significant bankruptcy filings among energy players and master limited partnerships.

The best time to buy in is at the crisis point of restructuring, when investors can get a handle on the new terms of debt and companies' ability to pay it down going forward, Deans said. That period is coming, especially for exploration and production companies, she added.

"My inclination is to take a barbell approach. I would own some strong players who will benefit from the shakeout in the sector, and I would start looking at names in the distressed area," she said.

Deans said she would steer clear of companies and MLPs that are servicing existing debt with more loans, as well as those firms whose cash flow is overly reliant on commodity prices.

Investors also face a choice of buying stock, which can be wiped out when a company enters bankruptcy, or debt, which may see its value reduced but which can also be converted into new equity after a restructuring.

The case for debt over equity

Distressed asset investor Marc Lasry has for months been calling energy debt the opportunity of a lifetime. Lasry's Avenue Capital has been buying up senior secured debt with the view it will either get paid off or end up owning the companies when the debt is converted to equity.

In the meantime, Avenue Capital is getting paid a coupon of around 12 percent on debt that it bought at 70 cents on the dollar and can now be had for as little as 40 cents on the dollar, Lasry told CNBC's "Fast Money: Halftime Report" this month.

"The only time you can buy is when everyone is panicked," he said. "When everybody starts saying, 'Look, oil's going back up,' nobody's a seller."

The key to investing in energy right now is whether one has the luxury of staying invested for up to five years, he said. "If you do, you're going to do fine. If you don't, you're going to get hurt."

Bonnie Baha, portfolio manager at DoubleLine Capital, said she likes that sentiment, but not necessarily the trade.

"Truth in fact is if we are still below long-term default rates; we obviously have a long runway. Until you start to see the default rate tick up in a meaningful way, I'd say you're way too early," she told CNBC's "Fast Money: Halftime Report" last week.

She pointed out that analysts previously thought crude oil wouldn't stall at $50 per barrel, but now they're scrambling to update models that factor in $20 per barrel.

"Until people get comfortable with where the bodies are going to fall, and until that default rate starts picking up, to my mind it's really difficult to make a case, and a lot of these have become very illiquid."

—CNBC's John Schoen produced the data visualization in this report.

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