The volatility in oil in 2016 has caused an unprecedented (well, at least since 2009) mispricing between E&P debt and equity securities, especially during March 2016. On March 8th, 2016 WTI oil prices had recovered 42% from the low of $26 on Feb. 11th - causing algos to bid up equity prices on bankrupt or almost bankrupt E&P companies. These companies had severely impaired unsecured bonds, most of which were trading below 10 cents on the dollar and some were trading below 1 cent on the dollar. These bonds did not move much on the oil rally.
The equity of these companies was not only behind secured and extremely impaired unsecured debt, but in some situations behind sub. bonds and preferreds as well. There was almost no scenario from a valuation standpoint in which there would be value left through the equity. If there was, the unsecured bonds trading at 5 would end up rallying through par to receive post-petition interest.
The trade was to short the equity of these companies vs. going long the unsecured bonds. Giving you a few possible scenarios:
- Oil trades lower and the E&P space continues to sell-off: the bonds and equity bond go to zero, which is a 0% return.
- Eventually the market realizes there is no value through the equity in a structure where the bonds are trading at pennies on the dollar. The bonds remain roughly unchanged and equity goes to zero.
- Oil rallies / E&P outlook improves. The bonds rally from low single digits to mid teens/ 20s. However, there is still zero recovery value for the equity and the equity goes to zero.
- The mispricing continues to get worse and the equity continues to outperform the bonds. While this will lead to a short term MTM loss, this trade is so mis-priced and the extremely low price on the bonds limit the sizing of the trade (usually 1Mx1M to 2x2mm) that most funds would welcome an opportunity to continue to put on more size at improved levels.
While we realize anyone can be a investor in retrospect, this situation was extremely mispriced in our opinion. We also realize that it is impossible to leg into the trade at the perfect time, the small MTM loss ($1-2mm per name) incurred if the equity rallies 100-200% temporarily would not be devastating to most funds and potentially welcome as the fundamentals are so skewed.
We highlight 10 companies in which this mis-pricing occurred in early March 2016. Most companies had enough shares outstanding and a bond price high enough/issue size large enough to put these trade on in sizes of 1MMx1MM to 3MMx3MM. While this may seem small, in a scenario in which the bond price doubles and the equity goes to zero the gain on a 1MMx1MM trade would be 2MM in PnL. This occurring 10 times gives 20MM PnL, i.e. real points on a $1BN fund.
LINE had 352MM Shares outstanding, giving the company a market capitalization of over $500mm at a point where LINE unsecured bonds were trading at around 5 cents on the dollar. Linn Energy filed for bankruptcy on May 11th, 2016. The unsecured bonds are currently trading at around 22 (+350%) and the equity is down ~99%.
Linn Energy 6.5 ‘19 vs Equity:
EXXI had 97.5MM shares outstanding, giving the company a market capitalization of over $120MM at the height of the dislocation when unsecured bonds were trading at ~4. On April 14th, 2016 Energy XXI announced it had entered into a restructuring agreement with senior lenders and filed for Chapter 11. Unsecured bonds now trade around 10 and the equity is down 98%.
EXXI 9.25 ‘17 vs. Equity:
MPO had 10.7MM shares outstanding, and a market cap. of ~50mm in early March. Bonds were are ~2.5 and the equity was at 60 cents, making this situations almost not transactable. Midstates Petroleum filed for bankruptcy on April 30th, 2016. The stock is down 75% and the bonds are roughly unchanged.
MPO 9.25 ‘21 followed by the Equity. You can see how the equity rallies much earlier and significantly outperforms bonds in early March:
PVAH had 88MM shares outstanding giving the company a market capitalization of ~45MM in early March when the unsecured bonds were trading at ~7, making a 1x1MM position difficult to put on as well. PVAH filed for bankruptcy on May 12th, 2016. The unsecured bonds are currently trading at 37 and the equity is down 94%.
PVAH 7.25 ‘19 followed by the Equity:
SD had 719MM shares outstanding giving the company a MCAP of ~300MM in early March when unsecured bonds were trading around 5. SD filed for bankruptcy on May 16th, 2016. SD bonds are roughly unchanged while the equity is down ~98%.
SD 8.75 ‘20 followed by the Equity:
WRES had 85MM shares outstanding giving the company a MCAP of ~$30MM in early March when the (illiquid) unsecured bonds were trading at half a cent on the dollar, making this trade hard to transact in decent size. WRES filed for bankruptcy on June 2nd, 2016. The unsecured bonds are a quoted around 2 cents on the dollar, and the equity is down 90%.
WRES 9 ‘22 followed by the Equity:
TPLM had 75MM shares outstanding giving the company a MCAP of ~$30MM in early March when the unsecured bonds were trading at ~17 cents on the dollar. TPLM filed for bankruptcy on June 29th, 2016. The unsecured bonds are current trading at 23 and the equity is down 99%.
TPLM 6.75 ‘22 followed by the Equity:
102MM Limited Partner Units of the MLP (different entity) were outstanding giving the company a MCAP of $150MM in early March when the unsecured bonds were trading at ~16. ARP filed for bankruptcy on July 27th, 2016. Currently the bonds are trading at around 20 and the equity is down 99%.
ARP 7.75 ‘21 followed by the Equity:
Halcon Resources Corp. (HK) had 120MM shares outstanding giving HK a MCAP of $150MM in early March when the unsecured bonds were trading at around 12. Ultimately filed for bankruptcy July 27th, 2016. Currently, the unsecured bonds are trading at around 24 and the equity is down 75%.
HK 9.75 vs Equity:
It is interesting to see how the equity (driven by algos) behaved almost exactly the same for all of these companies in early March even though they had very different capital structures.
While all of these companies ended up filing for bankruptcy, the results of the trade would actually have been better if they had not. We imagine the bonds would have rallied much more than the equity in a non-filing situation. Again, it is easy for anyone to look at trades in retrospect and play “Monday morning investor”, however this situation was so egregious that it warrants a discussion. There continue to be large dislocations between different assets classes in 2016, driven by uncertainty in the E&P space, Oil price volatility, and different investors (algos vs. value / distressed) and it does not take much capital in these situations to earn a very sizable return.
These dislocations are similar to the “informational dislocations” which we attempt to exploit at Volmanac - allowing us to deploy a small amount of capital in a short window which can earn a high return.
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