John Young, Jr.: Stop Propping Up Oil Companies – Forbes
Forbes quotes John Young, Jr. in its article entitled “Stop Propping Up Oil Companies.”
“This city is in a deep state of denial,” says a Houston broker who’s lived through three oil slumps before. We’re standing in a grand meeting room at the Houston Country Club, surrounded by well heeled Houstonians in evening wear. Construction cranes still dot the Houston skyline; every day more ground gets broken for another high-rise residential tower. “Everybody says it’s going to be different this time — the city’s more diversified than it used to be. But oil still supports everything here, whether they believe it or not.”
Perhaps most stunning: the number of lifelines thrown to troubled oil companies in recent weeks. Investors seem to be worried that they’re going to miss the opportunity to buy at the bottom, to grab a piece of a company that most likely wasn’t generating any free cash flow even when oil was at $100. Maybe the deep pockets that have passed out more than $10 billion in equity and billions more in loans in recent weeks know for a fact that oil prices are about to shoot back up. But I doubt it.
This week Linn Energy announced a $1 billion equity commitment from Quantum Resources, while Whiting Petroleum put to rest the rumors it’s on the auction block by announcing a $1.9 billion equity offering. Encana, which overpaid for Athlon Resources at the top of the market, somehow attracted $1.5 billion in new equity. Laredo Petroleum raised $750 million, Concho Resources $650 million, Oasis Petroleum $400 million and Rosetta Resources $200 million. Even Goodrich Petroleum, its shares down 90% from last year, grabbed $50 million in new equity and sold $100 million in debt. Comstock Resources issued $700 million in new bonds in recent weeks. It’s freshly subordinated debt has plunged in value to trade at a yield of 36%.
Energy XXI managed to sell $1.25 billion in second-lien notes at 12%. In doing so they subordinated their existing $750 million in senior notes. Those notes were trading at a yield of less than 2% last April; now they yield 26% (according to Finra’s TRACE site). Juicy, huh? Only if EXXI survives. Its shares are down 85% from last June, when it paid $2.3 billion to acquire rival EPL Oil & Gas at the peak of the market. Without higher oil prices there’s little chance the company will be able to generate any profits from its vast collection of mature oil fields in the shallow waters of the Gulf of Mexico.
“This is a leading indicator of an under appreciation of risk,” one baffled New York hedge fund manager told me Monday. He’s concerned about the potential devastating effect that a wave of high yield bond defaults and oil company bankruptcies could have on the broader economy.
As economist Ed Yardeni explained in his Monday note: “Repeat after me: Easy money is deflationary. I know that’s hard to believe since we’ve all been taught that easy money is inflationary, [but] easy money can also stimulate supply, especially in recent years because producers overestimated the ability of easy money to boost the demand for their goods and services. Easy money allows “zombie” companies to stay in business, thus boosting supply, even though they are losing money.”
The hard reality is this: propping up zombie oil companies is only going to make the downturn last longer. A new investment cycle is unlikely to begin until investors are willing to recognize their losses, shut down the woefully uneconomic operators and allow the strongest companies to consolidate. Too bad big egos will prevent that from happening any time soon.
We really shouldn’t be surprised. The Great American Oil Boom was built on easy money. And with the chance of a Federal Reserve rate hike diminishing, that easy money isn’t going away. Indeed, why stop now when the edge of the cliff is so tantalizingly close and we’re running so fast? With yields on Treasuries heading toward zero and investors looking everywhere for decent yields, the oil bubble will just keep on inflating until it well and truly pops.
Not all the aforementioned companies are zombies. But there are sure a lot of them trudging through the oil patch today. It’s these zombies that Saudi Arabia is looking to kill off by refusing to cut their oil production and make way for rampant U.S. supply growth. The Saudis can make massive profits even at $20 oil. The new generation of American shale drillers couldn’t even generate free cash flow at $100 oil. They’ve been outspending their cash flow for years. Enough already.
Chew on these numbers. U.S. oil and gas companies have $850 billion in outstanding bonds, according to this report from the Bank of International Settlements. That’s out of a $6 trillion total U.S. corporate bond market. This oil and gas indebtedness has surged in recent years, more than doubling since the last oil downturn in 2009. That’s twice the growth rate of overall corporate bond issuance.
It’s a similar story in the rest of the world, with $2.5 trillion total oil and gas indebtedness outstanding, more than 2.5 times what it was a decade ago.
On top of all that — the BIS report estimates that in 2014 there were $1.6 trillion of syndicated bank loans to oil and gas companies outstanding, up from less than $600 billion a decade ago.
It all adds up to more than $4 trillion in oil and gas bonds and loans. Much of this debt is naturally backed oil in the ground and cash flows from selling it. So how much $100 oil would you need to sell just to generate $4 trillion in REVENUES? Answer: 40 billion barrels. How much $50 oil would you need to sell? 80 billion barrels. How many barrels of oil did the world use in the past year? 35 billion barrels.
The thing is, much of the debt taken on by smaller shale oil producers will never be paid back unless oil prices go significantly higher than $100 — because even at $100 oil they weren’t generating any free cash flow.
According to BIS:
Much of this debt has been issued by smaller companies, in particular those engaged in shale oil exploration and production. Indeed, while the ratio of total debt to assets has been broadly unchanged for large US oil firms, it has on average almost doubled for other US producers – including smaller shale oil companies. These firms borrowed heavily to finance the expansion of production capacity, often against the backdrop of negative operating cash flow. Indeed, shale investment accounts for a large share of the increase in oil-related investment. Annual capital expenditure by oil and gas companies has more than doubled in real terms since 2000, to almost $900 billion in 2013.
Bernstein Research points out that historically the E&P business has recycled 85% of its cash flow into new capital spending. But beginning in 2012, when the shale boom really got booming, companies began outspending their cash flow. In the fourth quarter of 2014, as oil prices deteriorated, that spending-to-cash flow deficit widened to 128%, the worst period of outspending since the last plunge in 2009.
It’s easy for oil company CEOs to rationalize this away. Their explanation has always been something along the lines of: “Sure we’re not generating free cash flow now, but that’s because we’re investing for the long term, just wait a few years until we have a big enough base of production and the cash will really flow.” But we have waited a few years and now the cash flow deficit is bigger than ever. A much-touted 30% decrease in drilling costs isn’t going to make enough of a difference.
The oil boom has been great for the U.S. It’s put hundreds of thousands of people to work and contributed to vastly more plentiful and affordable gasoline than we would have thought possible a decade ago. Along the way it has been a big shot in the arm to the entire U.S. and global economy as we’ve emerged from the Great Recession.
Other bubbles were great too. The Internet Bubble of 2000 ushered in a brave new world of computing that has changed the world forever. And the sub-prime housing bubble of 2007 sure generated a lot of jobs for homebuilders and commissions for realtors. The Dutch Tulip Mania helped create a lot of pretty new flowers. It may be hard to see the oil bubble in the same light as other bubbles because there seems to be considerably more in the way of hard assets backing a share of an oil company than there was behind a share of Pets.com.
But are zombie oil companies really worth any more than Pets.com? Oil that costs too much to get out of the ground is worth about the same amount as a sock puppet and a flashy website that no one uses. Take a look at the 2014 10-k filing for Goodrich Petroleum, which has burned through mountains more cash than was ever thrown at Pets.com. Over the past five years Goodrich has generated $800 million in cumulative net losses on about $1 billion in oil and gas sales. Last year Goodrich made $333 million in capital expenditures. A full 79% of that was directed towards the Tuscaloosa Marine Shale trend of Louisiana and Mississippi where the company has 460,000 acres. The TMS, as it’s known is one of the most marginal of the new oil and gas plays. No doubt Goodrich found some oil there, but at current prices it’s simply not worth drilling for. Goodrich has more than $600 million in debt. And after recording a non-cash impairment charge of $332 million last year (reflecting the impact of lower oil prices on the value of its reserves), its balance sheet shows stockholders’ equity of -$16 million. At $3.30, Goodrich shares are down 90% from their 52-week high. This is one of those “zombie” companies that Ed Yardeni was talking about. And yet two weeks ago investors, including the junk bond managers at Franklin Advisers, gave Goodrich $50 million in new equity and $100 million for new debt.
We’ve already seen the beginning of a wave of defaults and bankruptcies in the oilpatch. Quicksilver Resources’ collapse was a long time coming. Others include WBH Energy, American Eagle Energy, Lucas Energy, Connacher Energy, Southern Pacific Resource and Sabine Oil & Gas, which is fighting with creditors over claims that it defaulted on nearly $600 million in debt.
More to come. A director of oil and gas financing at a big bank in Houston told me last week that he and his peers are currently in the throes of some ugly borrowing base redeterminations. Obviously, how much money an oil company can borrow against reserves depends upon the value of those reserves. With prices collapsed, a lot of tight oil now isn’t worth drilling at all — it’s worthless. Companies are busting the terms of their bonds and bank loans left and right — it’s common for borrowing covenants to require a company to keep their total indebtedness to within four times their annual EBITDA. But banks are waiving that requirement, for now. “We don’t know how to run an oil company; we don’t want to run an oil company,” says the banker. “Hopefully oil prices come back up this summer.” If not, by the time the next set of borrowing base determinations come around in October, there will be blood in the streets as many zombie companies will finally have no choice but to give up.
Egos will naturally get in the way. Private equity giant KKR in 2011 led a group that bought Samson Resources for $7.2 billion. It was a great deal for Tulsa’s Schusterman family that owned Samson, but has turned out terrible for KKR, as Samson is said to have lost $3 billion since 2011, including more than $400 million in 2014. It’s saddled with nearly $4 billion in debt. But KKR isn’t about to recognize losses on Samson unless it’s forced to. Lenders have waived covenants as the company attempts to restructure.
Business is booming for restructuring experts like John Young, senior managing director at Conway MacKenzie in Houston. He’s working with a number of oil and gas companies that have already fallen on hard times, as well some service companies and manufacturers, for whom “orders have dried up completely” as drillers cannibalize their fleets of mothballed rigs rather than buy new parts.
“We’re in the front end of the downturn,” says Young. “We’re living in a new world only 90 days old.” As a result, some are still laboring under the illusion that this downturn is temporary, that we’ll be going back to $100 in no time. But many more are waking up to reality. So if you invest now your capital will be deployed longer and you’ll need bigger results to generate decent return on investment.
The finest minds have no idea where oil is going. Most analysts I talk to think that U.S. oil production is set to top out later this year and fall into 2016 — an understandable result of drillers laying down more than 700 rigs and slashing capex by $65 billion. Yet this morning a group of sharp penciled analysts from energy consultancy WoodMackenzie told our gathered group of reporters that they thought U.S. production would not only continue to grow in 2015 but in 2016 as well.
Despite continued U.S. supply growth, WoodMac somehow expects prices to recover to around $65 by the end of this year. Their crystal ball is admittedly cloudy though, said WoodMac V.P. Alan Gelder. Soft economic conditions could erode oil demand, cratering prices further. U.S. refiners can likely “chew up” all the excess oil building up in storage, but what if they can’t? And then there’s Iran. The Iranian government says it could quickly add 1 million bpd to its current 1.1 mm bpd of exports. Skeptical analysts at Energy Aspects said in a report this week that 300,000 bpd extra is more likely. That’s still a material addition. And don’t expect the Saudis to cede market share to Iran.
The range of possibilities are endless. Look, it’s nice that some CEOs are finding new sources of funding to help their zombie companies survive this downturn, but these tight oil drillers already sucked up a trillion dollars and still can’t live within their cash flow.
If you’re a small-fry investor looking to get into oil now, you must be utterly convinced that oil prices will soon go high enough that they won’t need to come back to the trough for more cash. If you’re not convinced, then stay out of the way, watch the zombies die, and save your investment dollars for the survivors.