Scramble for Oil Patch Bargains

With the rapid decline in oil prices from a peak of around $110 a barrel to recent lows below $50 a barrel, a scramble has ensued to pick up bargains in the oil patch. A 2/13/15 Wall Street Journal (WSJ) report indicated that “bottom fishing” activity has picked up as hedge funds and private equity firms rush to buy beaten down stocks, bonds, loans, and other assets of energy and energy-related firms. New funds have been created to attract pension fund and institutional money to the energy sector in a bet on the cyclical nature of energy prices.

Robert Arnott, president of Research Affiliates and a well-regarded investment theorist, has said, “In investing, what is comfortable rarely is profitable.” Whether it is stocks, debt instruments, real estate, commodities, or various hard assets, investors know, looking at history and the cyclical nature of things, buying on price dips in the long run, while never guaranteed, often is profitable. Famed investors such as John Templeton or Warren Buffett proclaimed that truism over and over. Yet, as Arnott observes, buying during disruptions when uncertainty and fear rule, is not easy for the average investor. One might say that to achieve above average results, one must take above average risk. Easier said than done, given the realities of human nature.

Oddly enough, a different fear is arising concerning the energy sector, given a fast-emerging recognition of opportunity. There is concern that prices could rebound faster than big firms can raise the money to exploit bargains. After sinking below $50 bbl., oil prices have firmed up in recent days. As of February 16, 2015 Brent crude, the global standard, was selling for $61.75 bbl. West Texas Intermediate (WTI) sold for $52.82 bbl. In January, Brent crude sold for as low as $45.22 bbl.

We have seen this before. In 2008, oil prices plunged from about $108 bbl. to around $36 bbl. The WSJ pointed out that Exxon used the price distress then to gobble up competitors and the company may do so again. This is a familiar pattern. Big fish eat little fish. When times are flush, deals are made using leverage, i.e., borrowed money. When times get tough and profits are squeezed, fear increases that an issuer may not be able to pay interest or may default on the loan. Uncertainty creates bargains and the pros scramble to discern wounded eagles with recovery potential from turkeys that will not fly again.

Debt, whether described as a bond or a credit, normally is issued at par value of $1000. A bond quoted at 100 is a $1000 bond selling at par. A bond quoted at 960 would be a $1,000 par value bond selling at a discount of 4%. Recently, bonds of energy related companies were selling at discounts of 20% to 25% or more offering yields of 8% or more. Yields on bonds move inversely to the price of the bond. Obviously, when benchmark U.S. Treasury paper is quoted at roughly 2% (1.983% on 2/13/15), yields over 8% are attractive to income-starved investors. The 600 basis point plus spread in yield over 10-year Treasury paper reflects risk, investor uncertainty, a flight from risky assets, and the potential for default by the issuer. Referring to Arnott’s comfort zone, the excess yield is called a “risk premium.”

As the saying goes, one man’s trash is another man’s treasure. How does the average investor with capital to deploy take advantage of dislocations in the oil patch? Look for professional money managers who are raising fresh capital and who have the expertise and experience in energy-related or event-driven strategies to capitalize on opportunities. Managers of separately managed stock and bond portfolios, non-traded business development companies (BDCs), non-traded closed-end mutual funds, and specialty mutual funds may fit this category. Diversification is a buffer against any one issue or stock suffering a decline or default.

We saw that midst the slump in 2008-2009, investors with cash jumped on real estate bargains in various forms. It was hard to hit the exact bottom but now many of the bottom-fishers are smiling. Energy is enticing for similar reasons.

But, caveat emptor. Patience is required for such investments. Forecasts for oil and gas prices are all over the map. Time is more important than timing!

Lewis Walker is President of Walker Capital Management, LLC. Certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with Walker Capital Management, LLC. lewisw@theinvestmentcoach.com