May was a more difficult month for hedge funds, as evidenced by the growing number of monthly return sheets we have received. The energy-focused BlackGold Capital Management has had a strong year overall, although May has so far been the only month to take a significant bite out of its gains.
The BlackGold Opportunity Fund is up 9.1% for the year so far, although it was down 2.6% in May. The BlackGold MLP & Infrastructure Credit Fund is up 7% for 2019 after a 4% decline in May, while the BlackGold Insurance Dedicated Fund is up 8.9% for the year after a 2.8% decline in May.
The Opportunity Fund outperformed its benchmark, the Barclays HY Energy Index, which was down 4% in May and is up 5.7% year to date. The firm said the outperformance was because the Opportunity Fund holds a higher quality portfolio than the index. It cites “general malaise in the markets” and a “precipitous decline in Crude Oil” for the weakness in the portfolio. The S&P 500 was down 6.6%, while crude has plunged 16.3%.
BlackGold management noted that the energy credit space has been experiencing “blow-ups” on a regular basis, in which bonds plunge 10 to 30 points while “credits move from high-yield to stressed to distressed at lightning speed.” They believe most of the trading desks at “bulge bracket banks” have shifted from being providers of liquidity to being “match makers.”
“These desks historically employed the best-minds, the opportunists, and the capitalists – to take advantage of forced sellers or take a differentiating (and often contrasting) view,” they wrote in their May return sheet, which was reviewed by ValueWalk. “Hence price gaps of this magnitude were not common as banks stepped in and added risk to their books. Those days are gone. The analysts have left for the beach or the buy-side, the traders have moved to tier 2 shops and large largely waiting for buyers AND sellers to act on their ‘axe.'”
The BlackGold team also emphasized the importance for investors to know what they own. They describe active investing as “a key differentiator and a necessity to navigate and capitalize on such a trading environment.” They also believe now is a good time to “opportunistically” increase risk in the energy credit space.
They believe energy equities have become an “un-investible asset class,” noting that the E&P Index plunged 17.3%, while the Oil Service Index shed 21.5%. Both energy indices gave up the year’s entire gains, and then some. The E&P is down 3.5% now, while the Oil Service Index is down 6.8%. BlackGold management also said energy equities have three times the volatility of the S&P 500.
They noted that although crude and natural gas production have hit record highs, energy companies aren’t thriving as they should be. They blame poor capital discipline, “egregious growth plans funded by debt and a bloated cost (especially G&A) structure” for destroying “billions in equity value.” As a result, they believe energy credit is the best way to invest in the sector at this time.
BlackGold management also highlighted problems with the current energy maturity wall. Although previous walls haven’t caused any serious problems, they see two big differences now. One is that commercial banks have “evaporated,” while the other is that “distressed exchanges” are pushing the cost of debt and yields higher.
Their first point is that commercial banks have mostly left the sector or are only lending to companies that don’t really need loans because they are well capitalized or Investment-Grade. This has left energy companies which need to grow to grow into their capital structure without anywhere to turn. The BlackGold team heard at an energy conference recently, that of the 6,000 banks in the U.S., only 50 are active in energy lending. They expect the others to return when oil exceeds $100 per barrel.
Their second point is that many high-yield energy investors have seen what they describe as “the disastrous after effects of ‘liability management,'” or what they see as “a nonsensical approach to fixing a balance sheet problem made popular by a few cunning bankers, advisors and lawyers.”
“It involves exchanging debt at a discount to move up in the capital structure,” they explained, like by exchanging $100 in unsecured bonds for $60 of second-lien bonds.
This enables the company to see a discount on its debt while “a few investors can ‘protect’ their position by jumping ahead of other creditors.”
“In our memory – this approach has NOT worked as it creates more balance sheet complexity and only delays the inevitable: a thorough restructuring,” they wrote. “However, from what we’ve seen, advisors and lawyers benefit from the added complexity, as there are more classes of creditors to which they can provide their ‘advice.’ We have witnessed significant value leakage from such exchanges and ultimately restructurings.”
They do believe energy companies’ lack of access to capital and the market’s general “distaste” for the energy sector have provided strong investment opportunities on both the public and private sides.
This article first appeared on ValueWalk Premium