These 2 major oil producers are on the brink

These 2 major oil producers are on the brink

The collapse in oil prices has taken down a number of energy companies with it, all across the energy sector. By far, the one area of the oil and gas business that has been hit the hardest by plunging oil and gas prices is the exploration and production industry. These are the so-called “upstream” firms that focus on discovering and producing liquids. Exploration and production companies are entirely reliant on a supportive commodity price for cash flow, and with oil at $40 per barrel in the United States, they are in dire shape.

Linn Energy (NYSE: LINE) and Breitburn Energy Partners (NYSE: BBEP) took one step closer to bankruptcy when they both missed interest payments on their debt. Each issued press releases saying they are evaluating their options and that Chapter 11 may be unavoidable. Both companies are in penny-stock territory, but they are still publicly traded. This could lure investors into thinking they could be attractive turnaround bets—but this would be a huge mistake. Bankruptcy is looking likelier by the day.

The clock is ticking

To date, roughly 40 oil and gas producers around the world have declared bankruptcy, directly as a result of falling prices. Consulting firm Deloitte has published research indicating as many as one-third of all energy companies may fail, unless commodity prices rally significantly from present levels. Investors need to be aware that Linn and Breitburn may be the next two casualties of the oil rout.

In March, Linn Energy missed interest payments on three series of bonds due, for a total of approximately $60 million. At the time, it warned that a Chapter 11 bankruptcy filing could be unavoidable. Following the missed payment, Standard & Poor’s cut Linn’s credit rating to ‘D’—which signifies its very high credit risk. On Apr. 15, Linn made its interest payment—but it’s not out of the woods by any means. In a press release, the company notified investors that Chapter 11 is still a distinct possibility. The company proceeded to enter into a 30-day grace period for an interest payment due Apr. 15 for approximately $18.2 million on Linn’s 6.25 percent senior notes due May 2019, and approximately $8.8 million on Linn subsidiary Berry Petroleum’s 6.75 percent senior notes due Nov. 2020.

On Apr. 14, Breitburn missed an interest payment of its own, in the amount of $33 million. That put it into a 30-day grace period, after which an event of default occurs. It took the added step of eliminating its preferred distributions, having already suspended its common unit distributions several months ago. Breitburn is one step away from bankruptcy—it has notified investors that it is using this 30-day period to evaluate the best course of action, and it has hired investment banks to assist. It should be clear to investors that bankruptcy is perhaps the likeliest strategic option on the table.

During the first several months of the decline in commodity prices, exploration and production companies banked on their hedges to preserve cash flow. Linn and Breitburn had hedged the vast majority of 2014 and 2015 production, which helped keep them afloat. But now, those hedges are rolling off, and hedging derivatives are far more costly with oil and gas prices at depressed levels. And, there is little reason to hedge future production, with oil at such low levels. They have cut spending to the bone, sold off assets, and eliminated shareholder distributions. But they’re still burning through cash, and without hedging for protection, there’s nowhere to hide. Even if both companies make the necessary payments to get out of the grace period, bankruptcy is still the likeliest option. They are too highly indebted, and simply can’t make money at $40 oil.

Where the industry went wrong

Fundamentally, Linn and Breitburn simply have more debt than they can likely repay with oil and gas prices at current levels. When oil was at $100 per barrel, the credit spigot was wide open to energy firms, many of which couldn’t help themselves and levered up their balance sheets to purchase acreage and engage in corporate M&A. For example, Linn purchased Berry Petroleum in 2013 for nearly $5 billion including debt. The end result is that Linn took on a lot of debt, just when oil and gas prices were at their peak levels. According to Linn’s most recent 10-Q filing, the company has more than $10 billion in long-term debt on its balance sheet, compared with just $344 million in cash. Similarly,

Breitburn Energy acquired QR Energy in November 2014 in a $3 billion transaction. At the time, the merger made Breitburn the largest oil-weighted MLP in the United States. But it also saddled the company with a bloated balance sheet. Breitburn has $3.5 billion in total debt, with just $12 million in cash.

Effect on climate change

The shale producers like Linn and Breitburn aggressively ramped up domestic production, which ultimately led to their downfall. A separate consequence of the major increase in U.S. onshore production in premier fields like the Permian Basin and Eagle Ford shale, is that local environments have suffered as a result.

For example, in Oklahoma, which is at the heart of the shale drilling boom, earthquakes have increased in both frequency and intensity since 2011. Seismologists widely believe fracking, the process of injecting huge amounts of water into rock to release natural gas, to be behind the rise in earthquakes.

As a result, one of the positive aspects of oil and gas exploration and production companies curtailing their drilling activities would be a potential reduction in the amount and ferocity of earthquakes in U.S. states such as Oklahoma.

Companies to watch

Chesapeake Energy (NYSE: CHK): Investors should watch out for companies in the same industry as Linn and Breitburn. Chesapeake could be next. It is a major natural gas producer. Like Linn and Breitburn, Chesapeake loaded up on debt to spend heavily on acquisitions just when commodity prices peaked.

Chesapeake held more than $10 billion in long-term debt. As it continues to lose money—the company lost $12.5 billion over the first three quarters of 2015—it’s bleeding cash. Chesapeake’s cash on hand has fallen from $4.1 billion at the end of 2014, to $1.7 billion at the end of last quarter.

Vanguard Natural Resources (NYSE: VNR): Another major E&P at high risk is Vanguard. After acquiring two companies late last year, LRR Energy and Eagle Rock Energy Partners, Vanguard holds $2.2 billion in total debt and just $19 million in cash.

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. 

 

Originally published on May 12, 2016