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Bond of the Week: 30 October 2014

Enquest 5.5% 2022 - an update

    

Enquest 5.5% 2022 - an update

In the recent sell off in the ORB market the weakest name has been the oil producer Enquest. I thought it would be useful to look at the particular issues relating to this borrower rather than the malaise in the market as a whole. [I would make the simple point, nevertheless, that the ORB and credit markets as a whole are going through a risk off phase matching the declines in the equity market and ORB prices have not been suffering from any issues relating to the retail market itself].

The Enquest 5.5% 2022 came out in January 2013 but I additionally wrote a secondary market piece on 17th April this year. This was because there had been a large (judged by market conditions at that time) price fall of between 3.5-5% as a result of the issuance of a $ high yield bond which even after the sell off yielded 1 ½% more than the ORB bond. Not only did the high yield bond re-price the £ issue (although not fully) in a downward direction, many ORB investors were understandably peeved and felt the company had not acted in good faith with their pricing of the retail issue. 

What was my conclusion at the time? the company appears to have good prospects (most analysts have share targets substantially above the current level) and probably very good cash flow in the near future.” And “I think that at the current level (101.25) there is no reason to hold the bond. The differential between the US and £ bond is just too great.” I was wrong on the first point (along with all the equity analysts) but right on the second point that there was no reason to hold the bond as it was still too expensive as measured by the high yield bond. Incidentally the $ v£ differential has been maintained and on that basis the ORB is still too expensive. This is what has happened since April:


The yield on the bond. Note: post April it went nowhere, apart from a ½% tightening in the late summer, until it cracked in October.

Enquest 1
The equity priced alongside crude oil. Note a) as crude oil strengthened from $105 per barrel in February to $145 at the end of June, Enquest’s share price only marked time, b) once oil started its precipitous decline Enquest’s share price has matched it all the way down and c) the bond price did not respond in any meaningful way to either the crude or share price until the ORB market suddenly woke up to what was going on at the beginning of this month.
 

Enquest 2

The $ high yield bond. Note it is more difficult to track the price of this bond accurately and the chart starts in April (because that is when the bond was issued).
Enquest 3
Source Bloomberg.

Before writing this BOW I had hoped to speak to John Swinney the CFO. However, despite putting in a couple of calls he has declined to come to the phone. I believe I am not alone in finding him un-contactable and only the crème de la crème (i.e. large holders who have got it particularly wrong) have received an audience. It is understandable that he has been very busy, that many investors have tried to contact him and I am sure he is not hiding anything. However, I do think it would have been more upstanding for him to have come out and face the music.

I had determined on a number of questions to put to Mr. Swinney. Luckily although I cannot put these to the man directly, Janaka Ariyasena of Numis has just put out an excellent note on the Enquest bond. It contains all the interesting and relevant figures that should enable me to answer these questions, although Janaka does not give a conclusion as to whether one should buy or sell. Investment banks in the ORB sphere are not allowed to make recommendations (I am being serious). Numis is also not allowed to distribute this research, or let it fall into the hands, of non-institutional clients, so I am afraid you cannot see it. Bizarre isn’t it when the banks and brokers who market retail bonds are not allowed to make recommendations and when research on a retail bond is produced (without a recommendation), retail is not allowed to see it.

Beyond the oil price is there anything specific that has caused the equity price to be so weak? I was told in September that the threat of Scottish independence was putting pressure on the share price, but when the result went the right way there was only the briefest of pauses in the downward lurch. Of more significance is that there have been various delays in bringing Alma Galias production on line. At the time of the launch of the retail bond it was to have been at the tail end of this year but after the announcement of two delays, first oil is now expected in mid 2015. This delay has also meant a significant increase in costs such that total costs to bring the oil out of the ground at Alma Galia is around $92-$93 per barrel. 

What is the oil price they need in order to make an overall profit on their wells?  This is a difficult number to calculate as it depends on the performance of different projects, each with moving parts,  and each of whose break even may well be calculated in a different way because of varying national tax treatments. However, I understand the overall break even price of oil for Enquest is in the region of $80-$85 per barrel. This question is, nevertheless, a lot less relevant for bond holders than the next question. 

Since capital expenditure is a sunk cost, what really matters is: What is the production cost of oil? In other words what does it cost Enquest to pump oil once capital expenditure has already been spent.  In the First Half of 2014, Numis calculates the total production cost to be $45.9 per barrel ($10.5 for transportation, $35.4 for production).  I note that when the issue was launched Enquest had a production cost of $31.6 – so their cost of production has gone up. I believe as the oil price rises, demand for and therefore the cost of oil services in the North Sea increases. It may be that as the oil price falls this can operate in reverse.
 

Is Enquest under threat from the covenants on the bonds (and loan facility)? The bond and the loan has a requirement that net debt must not exceed 3X EBITDA. Numis has produced some useful figures. On a forecast of $100 per barrel, debt to EBITDA reaches 2.65X in 2015: so it is getting close (oil now stands in the mid 80s). The covenants are backwards looking so for the financial year end this year the covenant should not be a problem (oil to date this year has averaged about $106). The question is over 2015 when peak debt occurs (from 2015 if there are no further delays, the Alma Galia field should start to flow and debt begins to be paid back). Although this covenant may come close to being breached the company does actually have access to debt and therefore is not in danger of a credit squeeze. The $1.2bn revolving credit facility was undrawn at the half year point.

What could Enquest do about a covenant problem? The various alternatives are: 1) Phase capex on key developments, thereby lowering spend in 2015 (this is the most likely and most logical scenario) 2) Acquire assets that are immediately earnings accretive (this might raise eyebrows; go shopping to solve your debt problem). 3) Negotiate headroom on the net debt/ebitda covenant with bondholders/bank (maybe negotiate with the banks but how do you negotiate with retail bondholders?) and finally 4) Raise more equity capital (this would also be feasible). Enquest therefore should be able to take action to avoid a covenant breach baring a serious collapse of the oil price.

On capex, Numis forecasts $1bn for 2015 versus an $858 Bloomberg average. Some 70% of expenditure is on Kraken and about 30% of Thistle. On net debt the average forecasts are for $1.076bn in 2014, $1.318bn in 2015 and $1.230bn in 2016.

Conclusion. And so what do I think: do I think it is a buy? I did buy a small amount of the equity at £1.10, just before the independence referendum, on a gamble a no vote would send the price up. I got that one wrong (72p today). At 90% the bond yields a very tempting 7.3%. However, I think as in my April comment you have to decline to buy. Why? 

1) The pari passu USD bond still gives a handsome premium in yield at 9%. Even if you cannot access the bond (minimum denomination of $200,000, illiquid and in a foreign currency) it goes against the grain to buy a Sterling bond some 1.7% tighter than the USD bond. And you must assume that US High Yield investors know what they are doing when it comes to assessing what the correct yield should be. As another comparison the price of Ithaca 8 1/8% 2019 (CCC+ v. B for Enquest) has collapsed since September to 88%, mid, to yield 11.5%. Ithaca is another North Sea oil producer, although smaller (£270m v. £594m market cap) and with a worse credit by two notches rating than Enquest. Is 7% the right yield for a high cost North Sea producer in today’s market? Is the ORB or the High Yield market pricing the debt correctly; do you dare to say they have got it wrong?

2) Even if the management should be able to take measures to keep a lid on debt in 2015, Enquest is still a punt on the oil price. It is not inconceivable that the oil price could dive down towards their production cost. It is not so long ago that oil was consistently below $30. I got a note today from Barclays reducing their target for Brent Oil next year by $6 to $93. That is still a long way from Enquest’s $46 production cost, but the direction of adjustment is down. I do not need to remind you that oil can be very volatile and even if the oil price does not get breach Enquest’s production cost, the mere threat it might approach $46 would have a devastating effect on the bond price. 

3) Do not forget that the production companies that sit below the company that has issued the bond will have secured debt in place. ORB bondholders are structurally subordinated to this debt. In the event something goes terribly wrong, such as the oil price plummeting, you might find you get very little or no recovery. 

4) The share price has halved and is rated a buy or outperform by most analysts, with target prices from £1.20 to £1.70. Given this is not an exploration company in some unstable far flung part of the world, but a production company in the North Sea, bar the price of oil there should be many fewer unknowns to deal with in comparison to an exploration company.  If an investment in Enquest therefore comes down to a punt on the oil price, I am not sure you do not get much more upside with the equity while there is a fairly correlated performance on the downside (even if the magnitude of any loss would, at least to start with, be different). 

Is it a sell (at a probable loss)? The answer to that depends much on your own approach to investing and so I leave it to you to decide!

Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income. The author and or the LLP may hold a position in or trade in any of the securities mentioned above.

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