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Oasis Petroleum Bonds: Asymmetric Downside Exposure

Summary

I believe Oasis bonds are the initial weak link in the company's capital structure, and that the bonds offer definitively asymmetric downside risk.

Oasis bonds are at s real, high-probability risk of being diluted not only in "total value" but also in seniority.

With a mid-January commodity pricing deck giving us a preview of what would happen if Oasis drew on its revolver, I make the case for selling down exposure.

Oasis Petroleum (NYSE:OAS) is a name I've tracked for quite some time, but one I've never written about. To be clear, and to be fair to readers, in private consultations and risk-management sessions, I've been wrong regarding the ability of Oasis' equity price to "bounce back" from commodity pricing-driven lows; to this end, OAS has been quite impressive. But, in hindsight, it wasn't the equity that I should have been tracking for a risk-management thesis, it was the Oasis bonds. I believe bonds are the initial weak link in the company's capital structure, and that they offer definitively asymmetric downside risk. I believe, especially in light of broader, spatial opportunities (but also regardless of ancillary opportunity), that Oasis bond exposure should be sold down. Here's why.

Commodity Pricing Matters

First things first: commodity pricing matters. Sure, this isn't breaking news or ground-breaking analysis, but that said, it doesn't appear that the market is pricing in this presumably community knowledge. Oasis, at least in my opinion, will not be "free cash flow" breakeven on the full year (on a standard, GAAP basis) despite being what company management and investor relations like to call "free cash flow" breakeven. Why won't it be free cash flow breakeven on a GAAP basis?

In an effort to be brief, a severe downturn in commodity pricing (inclusive of Oasis' production realizations on a hedging-inclusive basis), coupled with ambitious CAPEX will not allow the defined calculation to balance. Put simply, I don't believe Oasis can create the revenues (all in, again inclusive of its hedging, its tightened resource play differentials, its operating into historical lows for vendor/service provide pricing, its operating out of 100% high-graded locations, etc.) to balance its cash-level outflows. I'll defend this in other forums, and potentially in a follow-on note, but I think the assumption is reliable and "generally accepted" at this point. Again, in an effort to be brief and to move quickly to my bond risk thesis, I'll move on.

That Oasis won't be GAAP cash flow-breakeven/positive matters. To explain this, and why it matters, we have to address one very important, very natural question: What's the difference between the two definitions (that of GAAP and that of Oasis)?

Standard GAAP-accounting defined free cash flow calculation is derived by subtracting CAPEX (capital expenditures) from operating cash flow. That's all. It's a pretty simple calculation and was drawn up that way in an effort to simplify execution of the calculation. Oasis' definition of free cash flow, which it throws around in its presentations and on its conference calls with little reiteration of the "Oasis difference", is Adjusted EBITDAX (a non-GAAP accounting measure that backs out ten different line items) less capex AND cash interest. CAPEX and cash interest are two of the single-largest cash outflows for oil & gas companies.

It's important to commit to memory that the company backs these out of its "free cash flow" calculations. With commodity pricing being so low, taking into account actual, real cash flow and how much of this actual, real cash flow is or is not heading out the door becomes important. It becomes paramount when trying to risk-manage, especially when trying to risk-manage capital structure vehicle risk (bond owners, I'm talking to you).

The key takeaway from the introduction of this note is that if Oasis isn't going to be free cash flow-breakeven/positive on the full year this means it's going to take on additional debt to fund operations (being that it...


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