Oil Surge Is Creating High-Yield Opportunities

As crude oil's strong rebound continues -- I'm seeing WTI quoted at $73.31 as I write this -- I have been looking into different ways to play the jump in prices. My knee-jerk reaction is always to buy shares of small E&P companies, as those enterprises are generally levered to crude prices both through financial leverage and flat corporate structures that allow for profits to drop straight to the bottom line as opposed to being sucked away by layers of middle management as they might be at Exxon (XOM) or Chevron (CVX) . Don't get me wrong, XOM and CVX are also beneficiaries of this move in crude, and you would be crazy to sell them now if you own them.

The fact is, though, an extended period of sustainably higher oil prices changes the basic economics of drilling a well. Higher oil prices also increase the value of the land upon which E&P companies lease their drilling rights, as that land is worth the current discounted value of future production volumes. As the "strip" -- the NYMEX forward oil futures curve shifts -- upward, an E&P company's assets are worth more intrinsically. It's a pretty neat scenario from an economic perspective, and if you've forgotten the bull run of 2013-2014, you should take your ginkgo biloba pills, because it was a wild time.

The fact remains, however, that not every energy stock has rallied in this move, though most have, and the core ETF measuring E&P performance - XOP -- has risen "only" 15.4% thus far this year. That's obviously a nice move, but it has badly lagged the 22.9% gain in the generic front-month WTI futures contract -- CL.1. As someone who invests in these stocks professionally for my clients, I can attest to the fact that one has to be greedy during the up moves. To hold these stocks for any amount of time you have to be convinced the producers will outperform the commodity. That has not occurred in 2018.

So, sometimes, a different view of the same situation is warranted. What dragged me into the oil group in 2013 was a search for yield, and that led to the purchase of bonds and preferreds of E&P companies. Obviously I had to jettison many of those positions as the market wobbled after OPEC's disastrous Thanksgiving meeting in 2014 and through the "oil bust" of 2015 and early-2016.

The strong shall survive, though, and this week I have been buying fixed income securities of several of the companies I got to know before the bust, and that are still paying elevated yields. Again, higher commodity prices produce higher cash flows, and thus, to use an oil industry phrase, "de-risk" those securities. This week I have been buying:

• CPE-A -- Callon Petroleum Co., 10.00% Series A Cumulative Preferred Stock CPE.A . Callon moved aggressively into the Permian at exactly the right time, and there is no reason any Callon security should be yielding 9.7%, as CPE-A is. That issue is currently callable, so that limits the upside in price, but I am betting that Callon management will continue to put incremental dollars of cash flow into the ground, not into buying back paper.
• 79970YAD7 -- Sanchez Energy 6.125% Notes due 1/15/2023. Yes, bond CUSIPs are harder to remember than symbols like FB or AMZN, but getting a 16.3% yield makes it worth the effort. I spoke with CEO Tony Sanchez at the JP Morgan energy conference last week in NYC, and I am convinced the company will soon act on its long-flagged move to sell off non-core assets. That will allow Sanchez to focus all its capital on its Comanche and Catarina assets in the Eagle Ford. Due to its South Texas location, Sanchez's crude is priced based on the Louisiana Light Sweet benchmark, which has recently seen a premium of $10/barrel over crude pumped in the Permian and benchmarked to WTI.

Those are two long-term buy-and-holds that allow an investor to have exposure to leveraged oil producers without the agitation of stock market volatility.

At the time of publication, Collins' firm was long XOM, CPE-A and 79970YAD7.