Surfing the oil bankruptcy wave — what investors should expect
Analysts have been warning investors for several months to expect a steep increase in the number of upstream exploration and production, or E&P, companies declaring bankruptcy. It seemed inevitable; the price of oil has fallen from above $100 per barrel at its 2014 peak, to a low of $27 per barrel in February. Oil has recovered somewhat, and currently trades at near $50 per barrel, but analysts have insisted that the economics of most highly indebted E&P operators remain far too challenged. A great number of firms are still losing money, even at $50 oil, and are not able to repay the mountains of debt they incurred to buy up acreage.
In 2015, not many bankruptcies came to pass, leaving many to wonder if perhaps the E&Ps could make it through. But finally, the bankruptcy wave may be here. Linn Energy (Nasdaq: LINE), Breitburn Energy (Nasdaq: BBEP) recently declared Chapter 11 bankruptcy, joining a host of others including Penn Virginia (OTCMKTS:PVAHQ) and SandRidge Energy (OTCMKTS: SDOCQ), which both have already gone bust. As a result, it may be only a matter of time before other E&P companies that are still standing decide to go the bankruptcy route. Investors holding out hope that some firms could still remain viable entities need to tread very carefully. The bankruptcy wave may be just beginning, and it is not likely to end for a long time.
Options left on the table
Initially, it was hoped that the highly indebted E&P companies could pursue debt-for-equity conversions to avoid bankruptcy. While it is an extremely dilutive action to existing shareholders, equity investors are at least still in the game and companies can avoid outright bankruptcy, which wipes out stockholders entirely. In press releases from both Linn and Breitburn, debt-for-equity conversion was a viable option on the table. But as they clearly stated, so was bankruptcy, and as it turned out, not enough debtholders agreed to the restructuring. The key sticking point was bank redetermination—the process in which banks conduct annual review of an E&P’s oil and gas reserves. The value of these reserves dictates the level of borrowing the companies are allowed to make. The last redetermination took place in April, and with commodities at such depressed levels, it seems that debtholders would rather fight it out in bankruptcy court.
Companies could use the steep drop in oil and gas prices as an opportunity to develop lower-carbon strategies to diversify their operations. But for the oil and gas E&Ps, this is simply not feasible. They are not generating enough cash flow to make debt payments, let alone invest in future growth opportunities of alternative forms of energy.
There is one environmental bright spot and that is with such low oil prices, global production is set to decline. This is already taking place in the U.S.; according to the latest Baker Hughes (NYSE: BHI) weekly rig count, total rigs in operation stood at 404 for the week ended May 20. One year ago, the rig count was 885. That is a 54 percent reduction in the span of one year. From an environmental perspective, this is at least an indication that harmful emissions will decrease as production falls.
This matters to investors of other E&P firms in precarious financial condition, because the bankruptcy cases of Linn and Breitburn serve as precedent that lenders are willing to let these companies go insolvent. This also matters from an environmental standpoint because many of these firms are leaving behind significant oil and gas producing assets, in some of the premier fields in the U.S., including the Permian Basin and the Eagle Ford shale. These assets are likely to be stranded, as it pertains to less-economically viable wells, potentially leaving that much more carbon in the ground.
It is also doubtful that these assets will be purchased by larger rivals. The Big Oil majors like Exxon Mobil (NYSE: XOM) and Royal Dutch Shell (NYSE: RDS.B) have only shown an interest in making very large acquisitions, such as Shell’s $70 billion takeover of BG Group. That deal made Shell the largest producer of liquefied natural gas. The established oil majors have deep pockets, and assets are cheap, but they need to make deals that are large enough to move the needle. Their production is so great that it does not make sense to buy up bankrupted assets, because these smaller companies are tiny in comparison to the majors.
Companies to watch
Investors need to keep a close eye on the oil and gas space moving forward, because the bankruptcy filings have probably not concluded just yet. As with Linn, Breitburn, SandRidge, and Penn Virginia, there are still several highly indebted companies that are losing huge sums of money.
Investors need to closely monitor companies like Chesapeake Energy (NYSE: CHK), Comstock Resources (NYSE: CRK), and even Vanguard Natural Resources (NYSE: VNR). These companies are cash flow negative—they are racking up massive losses each quarter, and with billions of debt on their balance sheets and debt-to-EBITDA ratios of 4x or higher, investors need to watch the industry very carefully.
Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.