Why Baytex Energy Corp. Could Easily Be 2016’s Top-Performing Oil Stock

Baytex Energy Corp. (TSX:BTE)(NYSE:BTE) is already way ahead of the pack for the year, beating the energy index by over 100% year-to-date. This could easily continue if oil prices hold up.

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It seems that sentiment around oil prices has drastically improved—as of March 7, oil price are up 40% off their 2016 lows. This rapid increase has been driven by a few factors. Firstly, U.S. oil rigs have fallen for 11 weeks in a row. This is a sign that U.S. production has entered into decline due to prices being too low to fund the capital budget required to replace the natural production declines that occur.

In addition, the market is recognizing the unsustainability of current prices, leading institutional investors to cover short positions and enter long positions. As a result, oil stocks have soared, and few have matched the performance of Baytex Energy Corp. (TSX:BTE)(NYSE:BTE).

How has Baytex performed relative to the price of oil? Since the low that began around January 20, Baytex has rallied over 160%, demonstrating that Baytex has become a preferred vehicle for bullish oil investors. If oil prices continue recovering, Baytex should continue to see strong performance.

Here’s why Baytex could continue to outperform.

Baytex’s balance sheet issues have depressed the price

Up until recently, Baytex has severely underperformed, and this is largely due to the fact that investors are concerned about its balance sheet. These concerns aren’t unrealistic—Baytex ended 2015 with a net-debt-to-cash flow of four (net debt is four times cash flow). This is above its peer group average of 3.6 times.

In 2016, if prices average about $36 for the year (futures strip pricing), Baytex is expected to have a net-debt-to-cash flow of 10.7. This is well ahead of the overall group average for junior and intermediate producers of 5.1.

Investors may be wondering what the big concern is with having such high debt levels relative to peers. First, Baytex has insufficient liquidity. That is to say, Baytex no longer has the cash or debt capacity available to continue funding itself. Second, Baytex breaches its debt covenants. Debt covenants are limitations that banks put on lending that if breached, could mean Baytex will see its borrowing ability severely limited.

Fortunately, a closer look reveals that Baytex’s debt concerns are overblown (especially if oil prices average current prices of about $36 per barrel for the year, and especially if they rise to above $40 per barrel as many analysts are forecasting).

Balance sheet concerns are overblown

First, Baytex currently has a healthy amount of liquidity. The company has credit facilities consisting of a US$200 million credit line and a $800 million credit line. This gives Baytex around $1.078 billion of available liquidity. As of December 31, 2015, Baytex had only drawn about $256 million from its credit facility, leaving it with $820 million of available room remaining.

This should be plenty for 2016. While Baytex has about $1.6 billion of long-term debt outstanding, none of this comes due until at least 2021, which means Baytex will not have to worry about any large repayments or refinancing.

Second, Baytex’s credit facilities do not expire until 2019 and they also do not require any mandatory repayments.

Baytex has taken steps to reduce its capital program to ensure it is not burning cash. Baytex originally released a capital budget that would be between $350 and $400 million for 2016. The company revised it down to $325-400 million, and at its recent full-year 2016 earnings release the company further revised it down to $225-265 million.

According to analysts at Royal Bank, Baytex should generate positive free cash flow at about $40 per barrel, and Baytex would only need to borrow slightly if prices remain at current levels of about $36 per barrel.

At the same time, Baytex has been actively engaging with banks to have its debt covenants relaxed (with plenty of success so far), and it has the option of pledging assets against its credit facilities to further loosen or remove its covenants.

This is good news for shareholders, because it means that not only will Baytex see rising cash flows as oil prices improve, but shareholders will also flock to the stock as they realize the balance sheet is more secure, which should drive the multiple up along with earnings.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Mancini owns Baytex Energy Corp. shares.

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