Buy and hold investors can find value in CXO bonds

Meredith Contente | January 7, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

ConocoPhilips (COP), the parent of Concho Resources Inc. (CXO), conducted an exchange of CXO bonds which was announced in December 2020 and completed in February 2021, in accordance with their acquisition of CXO. Under the exchange, CXO bondholders moved into new COP bonds with the same coupon and maturity.  The exchange also served as a consent solicitation to remove certain restrictive covenants from CXO bonds that were not exchanged.  COP did not receive 100% bondholder participation in the exchange and as such, there are remaining stub pieces for each CXO CUSIP.  These stub pieces trade significantly wide to the exchanged bonds given their lack of liquidity and provide an attractive pick up for buy and hold investors that are comfortable with the COP credit.

Exhibit 1. Single-A Energy 20-30yr Curve

Source: Bloomberg TRACE; APS

The trading differential between COP 4.85% 2048 bonds and CXO 4.85% 2048 (Exhibit 1) stands at roughly 60 bp (g-spread).  In fact, CXO 4.85% 2048 bonds are the widest trading bonds in the single-A energy space.

S&P Maintains Rating on CXO Bonds

CXO bonds are currently only rated by S&P.  Both Moody’s and Fitch withdrew their ratings subsequent to the exchange. Moody’s and Fitch noted that its ratings withdrawal was based on the fact that over 98% of pre-acquisition CXO debt was refinanced by COP in the exchange, and they felt there was not sufficient information to maintain ratings on the stub pieces that were left outstanding, as separate reporting requirements for CXO were eliminated with the exchange.  S&P took a different approach and continued to rate the bonds as they believe CXO is now a core subsidiary of COP, and will look at CXO as a part of the overall COP capital structure.  CXO’s rating at S&P was raised to be equalized with that of COP’s and the CXO bonds are expected to continue to be rated by S&P.  Given that the ratings are equalized, CXO’s A- rating will only move when COP’s ratings are upgraded or downgraded.

Parent Ratings are Maintained After Recent Acquisition

We note that COP recently closed on the acquisition of the Permian assets from Royal Dutch Shell at the beginning of December for $9.5 billion.  At that time, all the rating agencies affirmed COP’s ratings with Moody’s actually placing its rating on positive outlook.  Moody’s noted that the positive outlook reflected the substantial enhancement to COP’s scale in the Permian Basin.  Furthermore, they noted that the acquisition provided COP with capital flexibility as well as price resilience and should help COP achieve its goal of maintaining a high-grade base with a low supply cost.  This is expected to translate to better returns throughout price cycles while helping to lower carbon transition risks.

S&P noted that COP’s post acquisition credit ratios and liquidity are appropriate for the current rating and maintained its stable outlook.  S&P believes COP’s credit metrics will strengthen this year and that the company will build back its cash balance with strong free cash flow.  FFO/debt this year is expected to climb to the low 50% range, with the agency noting that an upgrade could occur if that metric increases above 60%.

Fitch highlighted that both the CXO acquisition and the Shell Permian acquisitions were credit friendly as CXO was a stock-for-stock transaction, while the Shell acquisition was funded with cash on hand.  That said, leverage remains solid at 1.1x (according to Fitch’s calculations) and underscores its stable outlook.  By increasing its size and scale with these acquisitions, Fitch noted that COP is in a better position to handle future downturns as size continues to remain important for E&P companies as it provides them with more liquidity options (i.e. – non-core asset sales).

A Larger Exchange in the Future?

With the exchange completed less than a year ago, COP has noted that they are not interested in doing an exchange on the remaining CXO bonds at this time. However, the company has noted that these bonds are likely to be part of a larger exchange or tender offer in the future as management was hoping for full participation in the last exchange.  While we cannot speculate on the timing of another exchange offer, we do believe that an exchange and or tender provide for further upside to the remaining CXO bonds.  Investors that are patient are likely to witness considerable upside if/when COP decides to conduct another exchange or tender.  In an exchange scenario, we would expect the bonds to tighten and trade on top of the existing COP 4.85% 2048 bonds.  Furthermore, a tender would also provide for good upside as we believe COP would likely be aggressive with their tender offer to ensure full participation.