I3 January 2015
NY Corporate Credit
Energy
Conclusion: E&P subsector — maintain Underweight
Keeping all of the preceding in mind, we believe investors should be
underweight the DB HY Energy E&P Index, and maintain this recommendation.
Last year, the DB HY Energy E&P Index was the worst performing sub-sector
in high yield. HY Energy was down -6% for the year, which compares to
overall HY being up -3.5%. In particular, we see little room for E&P subsector
outperformance as these smaller HY credits can't really continue their
aggressive growth strategies of the past as they try to make a path to neutral
FCF. In short, we believe these credits can stay in and around FCF neutral but
with little opportunity to expand the asset base and delever. We expect the
best they can do is survive and reach the other side of this commodity and
credit cycle. In particular, we see more value in the "higher quality" B/CCC
credits like Halcon (HKUS, BUY-rated) and EXCO Resources (XCO, BUY rated).
Given this lower-quality bucket has led the way down in energy, we believe
upside/downside is more positively skewed there. We understand the natural
tendency is for accounts to reach for quality in the BB area. Our concern with
this strategy is that these names have outperformed thus far. We worry that if
HY energy credits take a step down due to seasonally weak oil in 1H 15 that
these names will take a disproportional hit. Therefore, we suggest that
accounts stay in the BB-rated credits with upwards trajectory related to
possible M&A like Cimarex (XEC, BUY-rated) and to development of new
higher margin plays like Newfield (NFX, BUY-rated) in the SCOOP/STACK. We
believe both of these credits still also have IG upgrade potential even in this
market. Lastly, one of the most important reasons why we are maintaining our
underweight stance is driven by our suspicions that early 2015 fundamental
weakness in oil will mean that investors won't "miss the trade." Despite
positive data points around slashed capital budgets from many HY issuers and
even selective capital infusions (LINE/BX), we are moving back towards the
energy sector wides seen in December. More specifically, looking at LINE
bonds, which were the direct benefactor of an effective capital infusion from
BX, they are trading at pre-funding announcement levels. In our minds that
means the market isn't giving much credit to that increased liquidity either
because there's a perception that more capital is needed or on a macro basis,
that we just aren't there yet.
Deutsche Bank Securities Inc. Page 41
CONFIDENTIAL - PURSUANT TO FED. R. CRIM. P. 6(e) DB-SDNY-0044584
CONFIDENTIAL SDNY_GM_00190768
EFTA01357800