Trapeze Asset Management – Oil Opportunities – Debt, CEFs And More

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Oil Opportunities by Anthony Visano, CFA, Trapeze Asset Management

Taking The Advantage Of The Oil Sell-Off

The Special Situation Model1 held 30% cash entering 2015, earmarked for announced spinoffs and other opportunities. With the rapid deterioration in the price of oil and the commodity now selling below the global all-in cost of production, a number of asymmetrical opportunities have unfolded. The two most recent purchases illustrate the Special Situation process in action.

Given the significant issuance of junior energy debt over the past few years and ballooning leverage ratios due to the oil price decline, it is no surprise to see the bonds of most issuers decline materially. Beneath the rubble lies opportunity.

Mispriced Senior Debt

We have identified a few issues of domestic oil producers that have low costs, material hedges, low leverage ratios, high coverage ratios and senior ranking debt. For these reasons we see the average 8.5% yield to maturity (YTM) for these bonds as mispriced relative to comparable non-energy issuers and relative to the group’s own history.
We view a 150bps improvement in yield as the base case which represents a 9% capital gain. Combined with the current cash yield of about 8%, the basket of bonds offers a 1 year 17% projected total return. Should the YTM return to the mid-2014 6.5% level the return would be 20%.

Should oil prices fall below $40 for a prolonged period, the spread may widen further and the prices of the bonds may fall by 10%. Even under this scenario we ultimately see near par recovery.

Discounted Closed-End Funds

Typically, closed-end funds trade at or near their Net Asset Value (NAV) but occasionally inefficiencies arise and these funds trade below their NAV. Historically these opportunities arise in out-of-favor sectors. Given the seemingly one-sided sentiment toward oil, we recently explored for potential attractive closed-end oil funds and we were not surprised to find some interesting ideas.

We sought out discounted closed end funds given the margin of safety offered should our bullish thesis on oil prove incorrect. Additionally, discounted closed-end funds potentially offer enhanced rewards over a basket of oil equities should the spread to NAV narrow.

Closed-end funds are listed investment companies structured with a fixed amount of capital. The capital is invested by an investment manager, often focusing on an area of expertise like municipal bonds or commodities. Typically the assets are listed equities which allows for an easily calculated NAV.

In early January, we ran a screen and found 20 oil focused U.S. listed closed- end funds trading at discounts to their NAV. The discount for this group of 10% offered an opportunity compared to the group’s 4 year average discount of 1.8% (Fig 1).

Our review process included a thorough review of the underlying assets, the investment management fee structure, NAV growth history and trading liquidity.

We have focused our research efforts on the closed-end funds with at least 10% discounts to NAV. Our view is the current NAV discount is unwarranted for the majority of funds given the investment fund management experience and our review of the underlying investments.

Our base case estimate assumes the underlying holdings of these closed-end funds increases by 15% over the coming 12 months while the discount to NAV narrows to 5%, which results in a projected return of more than 28%. The projected return increases to 40% if the underlying holdings increase by 25% and the discount to NAV narrows to 5%. The obvious risk is a prolonged period of oil trading below the global all-in cost of production which could result in a further decline in prices for the funds’ underlying holdings. In such a scenario, a narrowing of the NAV discount could mitigate the downside.

Other opportunities

The Special Situation Model continues to hold 25% cash which the manager hopes to employ over the coming months. We anticipate investment opportunities in corporate actions, including already announced equity spin-offs. We hope to continue to provide further examples of our process in action.

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