Friday letter: Fancy a dip?

A large number of the biggest names in distressed investing have said they want focus on stressed energy plays. With oil under $50 a barrel, the potential upside is hard to deny but are there enough of the right kind of assets to go around?

Investing in struggling oil companies offers fund managers a two-pronged potential upside, explained Avenue Capital’s Marc Lasry when he appeared on CNBC’s Squawk Box earlier this month. As well as loan-to-own opportunities, investors can also look forward to selling off the commodity at a premium in two years when prices recover declared a bullish Lasry. PDI was convinced on the spot and immediately started raising the debut PDI Distressed Energy Fund. And so did everybody else.

Naturally, it’s not that simple. A quick survey of the oil industry shows that the majors like Shell and ConocoPhillips have raked in so much cash over the last five years that they are practically debt free. With a fall in free cash flow, they will – and have – cut investment projects, so still have strong balance sheets.

Distressed players will of course ignore these robust majors and move onto the over-levered companies. Those are to be found in emerging markets (Brazil’s Petrobras or Russia’s Rosneft) and the baby boomers of the US shale oil sector.

But buying in to the less charted parts of the energy sector during a volatile period is risky. You may be able to invest in Rosneft’s large debt pile (a mix of unsecured term loans and off-balance sheet structured pre-payment facilities with commodity traders and Chinese oil companies) but there's not much incentive for a loan-to-own player. Trying to realise an asset would mean enforcing in the London courts (the loans are generally drafted under English law) against the largest oil producer in the world which also happens to be a state-owned company. And that state is Russia, tightly controlled by Vladimir Putin who engineered the resource nationalism that dominates its energy sector. Good luck with that.

Some may buy into the relatively cheap debt of these state-owned giants betting on repayment at par. They may win, but with Russian companies and banks locked out of financial markets by sanctions, the reward is unlikely to match the risk. Emerging market oil plays are better left to the currency specialists and government debt investors with an appetite for risk.

So that leaves Oaktree, Apollo, Avenue Capital, Blackstone/GSO and others salivating over the opportunity within the US shale companies. Total debt for listed American energy exploration and production companies has reached €260 billion, according to Bloomberg, and the sector makes up 17 percent of the US high yield bond market.

There are over 200 listed energy companies in North America with a net debt to EBITDA multiple of over three times, according to S&P Capital IQ data. Those companies range from moderate leverage of 3.01 times right up to Cheniere Energy Partners’ breath-taking 59.4 times leverage multiple.

But while these data points are a helpful starting point, they are too crude to separate the good from the bad. A closer look at the capital expenditure of the same companies reveal several that may be able to take the ‘hunker down’ approach of the oil majors. The opportunity set will also be sharply divided on the basis of asset quality. Strong assets could help float a weak balance sheet through the current turbulence. That’s certainly the approach taken by LINN Energy which recently slashed capital expenditure while agreeing a reverse equity for debt facility with GSO Capital Partners.

The big debt firms making public statements on the opportunities within energy need to move fast to catch this tide. Getting funds in and deploying capital quickly will be key to realise the full return potential. And it's safe to predict that there will be pain as well as gain. The last funds to take a dive into the sometimes murky depths of the energy industry could find that it’s a shallow pool.