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Diverting Capital to Buying Back Debt an Opportunity For Distressed E&Ps, Says Raymond James

With the oil futures curve not forecasting a price rebound above $50/bbl until 2019, it may be a better play to pay down debt than invest in upstream development or acquisitions, Raymond James & Associates Inc. analysts said this week.

Drilling, along with acquisitions and divestitures, have been the modus operandi for risk takers in the exploration and production (E&P) world. However, discount debt repurchases offer a "commodity insensitive, safer return on capital," and that may be a better option today, said J. Marshall Adkins and his colleagues.

U.S. E&P companies long had outspent operating cash flow, "with production growth being the all-important goal," and Wall Street had been more than happy to accommodate through equity and debt offerings. But that was yesterday.

"With bond prices trading off by 50% or more, E&P companies now face the more relevant decision whether to allocate operating cash flow to either drill/complete new wells or to buy back debt and reduce leverage," Adkins said.

"In a $35/bbl and $2.30/MMBtu price environment, returns are, on average, relatively lousy, with only the best Permian drilling acreage delivering 30%-plus rate of returns and the vast majority of the E&P industry drilling portfolio realizing sub-20% rates of returns or even negative rate of returns."

In contrast, with the sell off in the price of bonds, leveraged companies might be able to buy back their debt at yield to maturities (YTM) of 30% or more -- an option that would reduce leverage at a faster rate versus drilling new wells, as long as the YTM is higher than the expected rate of return.

The return wouldn't be dependent on any prevailing commodity price assumption, and it's a new phenomenon that has only developed because of the steep sell off in the price of the bonds.

Even with increased drilling and productivity efficiencies, producers only now are realizing sub-20% internal rates of returns on their drilling programs everywhere but the Permian Basin, where the return rates are in the 30%-plus range, according to Raymond James.

Based on an expectation by Raymond James that only operators with high YTMs would repurchase debt, "we estimate that over $26 billion in outstanding unsecured debt is attractive for repurchase and that the resulting reallocation of operating cash flow from capital spending to debt reduction (both unsecured and secured) could represent 10%-plus of total spending by high yielding U.S. independent operators," Adkins said.

The question is, if the debt markets are correct that E&Ps are in dire straits and their bonds deserve to trade at pennies on the dollar, would the distressed E&Ps survive long enough to buy back enough debt to matter? To determine if that was the correct answer, Adkins and his colleagues attempted to quantify what depressed bond prices were saying about the survival prospects of the coverage group.

A straightforward link exists between bond spreads and the probability of a given operator defaulting over time, Adkins said. Current E&P bond prices "seem to imply that only a few of the most levered names within our universe have a greater than 50% chance of insolvency within the next one-year period."

About half of the operating cash flow is composed of names in the "very high risk bucket," with Chesapeake Energy Corp. accounting for 25% by itself.

"While Chesapeake will certainly face risks over the coming year, we do not currently foresee a bankruptcy in 2016," Adkins said. "Thus, even if a portion of the remaining names did default on their debt, our thesis would still largely remain intact."

Based on the analysts' estimate that only operators with very high yields to maturity will repurchase debt, with a YTM above 30%, more than $26 billion in outstanding unsecured debt could be attractive for repurchase. The resulting reallocation of operating cash flow from capital spending to debt reduction, both unsecured and secured, could represent 10%-plus of total spending by high yielding U.S. independent operators.

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