Blackgold Capital Management, the energy focused investment firm backed by KKR, has continued to outperform the rest of the energy market thanks to its bets on high yield energy credits and active investing, that’s according to hedge fund’s second quarter letter to investors, a copy of which has been reviewed by ValueWalk.
During the second quarter, Blackgold’s benchmarks, which include the Barclays HY Energy Index, VanEck Oil Service ETF and the Alerian MLP Total Return Index all produced a negative return for investors as the outlook for the oil sector remained uncertain. Even against this backdrop, Blackgold was able to chalk up a positive investment performance for Q2.
High Yield Energy Credits is a buy
Blackgold's specialism is high yield energy credits, an area of the market where the firm sees the potential for "multiple years of above-average return potential in this new energy up cycle." High yield energy credits in this sector continue to trade over 100 basis points wide of the overall high yield market, compared to the historical average of 100 bps to 200 bps tighter, which leaves "much room" for further price appreciation.
Over the past three years, the oil sector has been dragged through the wringer as the price collapse was so sudden and aggressive, it caught many smaller producers, who had been predicting years of oil price stability, off-guard sparking a wave of bankruptcies and aggressive cost cutting. According to Blackgold's second quarter letter, even though oil prices have stabilized over the past 12 months, the industry is still adjusting to the new normal. Companies are focused on increasing liquidity and lowering cost structures further still, which is great news for creditors. Against this backdrop, Blackgold believes that the worst is over for the sector, and 17 months after the cycle low, there's still plenty of opportunity for risk tolerant investors.
Shale industry breakevens have fallen to roughly $50 per barrel today, against $75/bbl in 2014. And even though the shale industry has seen a broad rebalancing since 2014, Blackgold believes there could be further pain ahead for smaller producers if oil prices trade below $40 for a prolonged period. This would create "pockets of energy market stress" leading to "additional distressed/restructuring opportunities for outsized credit returns."
One section of the oil industry Blackgold likes, in particular, is mid-stream. The market for mid-stream credits is worth ~$400 billion. The firm notes that these loans have performed exceptionally well over the last decade.
Investors have been rewarded with better risk-adjusted returns than MLP equities due to their lower correlation to oil price swings and the broad equity market indices, as well as lack of distribution cut risk and creditor protections. Indeed, many well-known MLP industry heavyweights have announced distribution cuts since the oil slump began, protecting their balance sheets as a strong financial position is required to support growth.
Mid-stream companies are reliant on capital markets to fund their growth. Therefore they are incentivized to "retain balance sheet discipline and maintain better ratings and a lower cost of capital," a negative for equity holders, but a definite positive for creditors.
The letter ends off stating:
Many shale oil producers are dependent on external sources of funding and still need oil prices north of $45 per barrel on a sustained basis to grow production. Many investors are also fatigued by the length of the downturn in the energy sector and are no longer willing to fund uneconomic production. While a range-bound commodity price environment is not ideal for most energy investments, the industry’s focus on playing defense via credit positive actions such as balance sheet repair, decreasing leverage and lowering cost structure benefits energy credit.