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Analysis & Comment:  

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Following the announcement that there was to be the first USD bond for the North Sea oil company Enquest and which was initially rumoured to come with a much better coupon than the current ORB bond (although subsequently it came at an even more generous level than first rumoured) the existing £ retail bond fell substantially. From peak to trough the price fell 5% but has since posted a partial recovery to show a decline of 3.5% from the price prior to the new issue announcement.

I had been going to write a Bond of the Week earlier on this subject but I was waiting to join a conference call with the company, kindly organised by their broker Numis, and this only took place this week. As old news it is possible we have seen all the price action/ correction there is to be in this bond. Before I attempt to ask and answer various questions on this development I set out the terms below of both issues so the two bonds may be more easily contrasted and compared.

 

Type: £ ORB bond $ Bond
Issuer: Enquest PLC Enquest PLC
Issue size: £155 million $650 million
Coupon: 5.50% 7%
Rating: Not rated B
Maturity: 15th Feb 2022 15th April 2022
Call: No call Call April 2017 @ 105.25
Mid Price: 101.25 100.75
Yield: 5.30% 6.84%

 

How is the company doing?

The company’s share price had a wobble at the end of March after the announcement of their December 2013 year end. The main reason, as rather convincing explained by Jonathan Swinney, Enquest’s CFO, was due to some modest production delays, particularly to the Alma/ Galia field.  These had previously been signalled to the market but analysts had not always taken the hint and altered their official/ written up barrels per day estimates. Enquest now estimates production for 2014 of 25-30,000 (bpd) barrels per day whereas some analysts prior to the year end results had been going for up to 35,000 bpd. The Alma/ Galia field has a very rapid payback (although the life of the field is short) . The 1970s field is not a new one but had previously been moth-balled in a lower oil price era. A short delay in bringing production on stream from Alma/ Galia has a large effect on bpd.

It is my experience that all resource extraction companies live to disappoint on timing, if nothing else. There is all that filthy lucre in the ground which would be worth so much in the market place and you are assured there is no problem getting it there. And then there is a fire, a problem in the benification department, the weather is too hot, the weather is too cold, the workers are on strike or Old Mother Hubbard has come to stay. I suppose against all this, the new to me excuse of high winds doesn’t seem too bad (they caused an interruption of 45 days when the cranes could not operate).

To sum it up, the outlook for the company seems good. We know nothing (untoward) today that we did not know when the £ ORB bond was launched in January 2013. In fact I asked John Swinney whether Enquest were today where they broadly expected to be at the time of the launch of the £ bond. He said they were. I then said that given bond spread were tighter today than they were in January 2013 and given that it had just cost him 7% to borrow in the $ market where interest rates are similar, could we conclude that he had managed to get away a very good deal with his ORB bond. Here his answer was erudite but less clear. However, cutting out his natural desire not to be seen to having taken advantage of his Sterling bond holders, I think we can take it that yes, Enquest got away, for them, a very good deal when they placed the 5.5% 2022 bond in January 2012. Therefore what we need to address is not new doubts about the credit worthiness of the company but the matter of relative value between the $ and £ bonds

Differences in terms between the two bonds.

i) The USD bond has an issuer call in 2017, but at a substantial premium of 105.25, which then drops away to a call at 100 in 2020. Here the ORB bond certainly has an advantage – you don’t want to give away options to issuers without them paying for it. All things being equal you would expect the $ bond to be called in 2020 when two year financing at 7% would be seen as very expensive. However, how much is it worth not to have a call? I am not sure, but not that much given the high initial cost of the call; an 1/8% – ¼%?

ii) There are differences in the covenants. The ORB bond has various financial maintenance clauses. In particular a maximum leverage ratio of 3 X ebitda (currently 2 X and forecast to decline rapidly once Alma/ Galia comes on stream) and interest leverage of 4 X. On the conference call it was suggested the USD bond does not have these maintenance clauses. This seems strange as normally high yield USD debt is very strict when it comes to such matters. Whatever, the answer it doesn’t really matter because given both bonds have the same issuer, and given cross default clauses, each bond will benefit from the clauses in the other bond’s prospectus. Indeed the tighter the clauses of the USD bond the better it is for the ORB bond.

However, there is one crucial difference, although it is very technical and legalistic so I am not qualified to give definitive answers as to its importance. Enquest is organised as a holding company (which has issued both bonds) and below that there are operating companies which will have issued secured debt. The USD bond has guarantees (senior but structurally subordinated because the guarantees are not secured) from these subsidiaries. The Sterling ORB bond does not. In the event of default once the subsidiary has paid off the secured debt then the USD bond would get first bite of any sums left over –  implying a very substantial improvement of possible recovery rates. However, it can be more complicated than that as these subsidiaries may have received cash from the parent (the cash originating from the bond issues) via inter-company loans. This would make the ORB bond a senior unsecured creditor of the subsidiaries alongside the USD bond. It may get yet more complicated as, in the event that disaster struck for bond investors, the “double dip” principle could come into play. Both bonds would have an equal claim on money from subsidiaries via inter-company loans but the USD would have an additional claim because of the guarantee. Therefore (ignoring issue size) for each £100 of recovery £66 would go to the USD bond and £33 to the ORB bond. All very complicated but potentially the USD has a substantial advantage here.

However, there is a solution. On page 182 of the USD prospectus it says in respect of the ORB bond The Company may elect, following the Issue Date, to have the Guarantors also guarantee the debt of the Company under the MTN Program”. No mention was made of this during the conference call. It may well be that if you don’t ask you don’t get. Therefore if you are an investor in the ORB bond and would like these guarantees then I suggest you get asking. InvestorRelations@EnQuest.com .

iii) The Sterling bond has denominations of £100. The USD has denominations of $200,000. Not only is there a currency issue, the size of the denominations effectively closes the USD bond to nearly all retail investors. The USD bond is an arms-length valuation tool that in practice cannot be invested in.  I might also add that while many Sterling investors have keenly looked at the USD bond and are none too happy about the much greater yield the USD investors have got, it is a one-way mirror between the two markets. I am sure the high yield market – sophisticated and huge – does not care two hoots about the ORB market when reaching its conclusion on valuation. This is not to say, of course, that they are always right and we are always wrong. It is just that this is a bit like foreign policy when the US State Department can’t quite remember who we are although they would like us to toe the party line.

The rating and explanation for the 7% USD coupon.

The USD bond is rated B, and if it were rated so would the £ bond be bar the question of the guarantees from the subsidiaries. This surprised the UK market who had assumed the theoretical rating of their bond was around BB before being rudely awakened by the arrival of the $ bond. I expect Enquest itself was rather surprised.

The explanation for the low rating is that S&P starts with an anchor rating of BB- for companies comparable to Enquest and then adjusted it because of Enquest’s small size – both market cap and bpd (40,000 bpd is apparently an important milestone), the lack of diversification as all assets are in the North Sea and that the company has not issued a rated bond before.  Some would see it as no bad thing that all assets were in the North Sea and not in the usual sort of place you find oil fields in.  John Swinney expressed the hope that as gearing improved as first Alma/ Galia and then the Kaken field come on stream the rating will receive an uplift. However, I would make the point that Enquest does not pay a dividend and is unlikely to do so in the near future because there are a lot of attractive opportunities in late life fields. If that is the case you would have to think that as cash flows in from their new fields it might well get spent on new acquisitions rather than reducing gearing to ebitda – despite their suggestion (but not undertaking) that they would reduce gearing.

When they embarked upon the borrowing in the high yield market, they had expected to have to pay a coupon of somewhere between 6 3/8% and 6 5/8%. However, Tullows (BB-/ B1) spoiled their market by coming with an issue of 6 ¼% just as they were launching. On learning that they had to pay a 7% coupon it was thought to be both too damaging for reputation reasons to pull the issue and also even paying 7% they could put the money to good use. We were also told that they had demand for $1.5bn so that proved how attractive a prospect they were. I would have thought if they had offered 7% in sterling they would have had plenty of takers as well. Also if high yield bonds are not oversubscribed as new issues  they very rapidly go South. Further Mr. Swinney explaining how beneficial it was for the interest of the company and therefore ORB bond holders to have borrowed the USD money wore a bit thin. The ORB holders are not equity holders. They can hardly benefit from the company having borrowed at much wider terms in another market.

Conclusion: I think we have to look forward and not over our shoulder. The US investors obviously got a much better deal and Enquest borrowed in Sterling on terms that were probably too favourable to them even at the time and even without having had the surprise of a bad rating. However, the company appears to have good prospects (most analysts have share targets substantially above the current level) and probable very good cash flow in the near future. It is just that maybe in Sterling there has been a mispricing of debt versus equity. The US high yield market can certainly get things wrong and they may well have a parochial attitude but they are the dominant force and should be seen as the correct pricers of Enquest’s debt. Against that, overall the ORB market is very firm with little supply. It also shows good liquidity and any bonds that fall under par have the attraction of exemption from capital gains tax. This will and has acted as a strong support, especially as investors start to blank the unpleasant experience of the US issue from their minds. However, the news from the US must cap the upside. One well respected figure in the market very plausibly suggested that the bond will therefore probably be in for a long sideways movement; capped both on the upside and downside. Personally I think that at current level (101.25) there is no reason to hold the bond. The differential between the US and £ bond is just too great. If the market is always right then the market is the US market. Therefore assuming you are able and willing to buy equities and still like the company I would consider selling the at best indifferent ORB bond and buying the shares instead. I have not had the bond for some time but I will have a flutter on the share. I have been following it for some time and the recent dip, I hope, presents an opportunity. Meanwhile if you continue to hold, make sure you get the guarantees from the subsidiaries put in place.

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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