A wave of bankruptcies might be about to hit the oil industry
The collapse in the energy sector has progressed through several stages thus far. When oil prices started falling from $100 per barrel in 2014, first there was denial. Analysts and economists were fairly convinced the decline would be short-term, as oil remained a critical global commodity and demand was growing in the emerging markets like China and India. But when oil kept declining, the next step was shock—investors saw the huge declines in the equity and debt markets, and began to wonder where the bottom would be. Now, as oil appears to have at least found a temporary bottom at $26 per barrel, there is a renewed hope among investors. But what investors are not anticipating yet is the next likely step in this painful process: a massive bankruptcy wave.
Due to disastrous decisions on the part of many small exploration and production firms when oil was at $100 per barrel in the United States, the risk of insolvency is very real and significant for many smaller firms. Investors should be aware that the market is now pricing in significant insolvency risk for many of these firms.
The industry at the highest risk right now
To be sure, the super-majors like Exxon Mobil (NYSE: XOM) do not face insolvency risk. Global integrated majors like Exxon Mobil and its competitors have extremely deep pockets, the ability to raise massive amounts of capital with relative ease thanks to strong credit ratings, and they also have large refining businesses that earn higher profit when oil prices decline.
Instead, the industry most at risk right now is a particular niche within the broader energy sector known as exploration and production, or E&P firms, focused on the upstream corner of the oil and gas spectrum. Exploration and production companies are reliant on supportive commodity prices to make their business operations economically viable. These are companies like Linn Energy (Nasdaq: LINE) and Breitburn Energy Partners (Nasdaq: BBEP), which explore and drill for oil and natural gas. Upstream firms like these are hit the hardest when commodity prices decline.
Making matters worse is that several oil and gas companies loaded up on debt in the past several years, back when the industry was booming. When oil was at $100 per barrel, the capital markets were wide open to upstream companies, and many companies took advantage by levering up their balance sheets to purchase acreage, engage in corporate M&A, and ramp up production.
For example, Linn purchased rival E&P firm Berry Petroleum in 2013 for nearly $5 billion, including debt. That decision clearly backfired: 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. Of course, November 2014 was nearly the top in oil prices. And the deal also saddled the company with a bloated balance sheet. As of its most recent 10-Q filing, Breitburn has $3.5 billion in total debt, with just $12 million in cash, and losses of $2.6 billion last year.
The reality is that Linn, Breitburn, and producers in general took on far too much debt to finance these activities, just when oil and gas prices were at their peak levels. Now, it is clear that these decisions were disastrous: these companies are losing billions, bonds are trading at pennies on the dollar, and Linn and Breitburn have far more in debt than they can repay with oil at these suppressed levels. Linn recently stated it will not be able to release its 10-K filing on time, and that it is likely to breach several of its restrictive covenants in 2016 if these covenants are not waived or modified.
Investors: circle April on your calendars
The next monumental event facing the upstream energy firms comes in April. This is when many E&P firms face a redetermination of their borrowing bases. In other words, the banks who loan money to E&P companies are going to reassess the value of the oil and gas firms’ stated reserves, which are often used as collateral or security to back the loans.
It goes without saying that at $30 oil, the value of reserves will be restated much lower than they were at the last redetermination. If that indeed happens, banks will significantly reduce the level of future lending provided to these firms. This is a significant risk in itself of insolvency, as the credit facilities extended to upstream producers has been one of the only things keeping their liquidity intact during the crisis.
Breitburn warned investors of this risk in its 2015 annual earnings report. The company stated that as of Feb. 25, it had $1.2 billion in borrowings outstanding under its current credit facility, down from $1.8 billion as of Dec. 31. Breitburn’s borrowing base is scheduled to be reset in April, and the company notified investors that it expects its borrowing base to be “significantly decreased.” Furthermore, the company faces an additional redetermination in Oct., and it said “if commodity prices remain depressed or further decline, we expect our borrowing base to be reduced again at the subsequent borrowing base redetermination in October 2016, which could further impact and limit our liquidity.”
Without sufficient near-term liquidity, it will be nearly impossible for these companies to pay their bills. Hedges are rolling off, and commodity prices are still below levels of economic viability. This means it is likely that many companies in the upstream E&P space will either declare bankruptcy outright, or pursue a debt restructuring. In that case, companies could convert debt to equity—which although not technically a bankruptcy event, shareholders would be wiped out nonetheless.
The final takeaway
The oil and gas industry is often referred to as a boom-and-bust business. What this means is that management teams need to exercise a fair degree of prudence during boom times, so as not to over-extend themselves just before the cycle turns. Unfortunately, most upstream companies seemed to think the party would never end. Companies like Linn, Chesapeake, and many others over-leveraged themselves on debt, engaged in fruitless M&A, and ramped up production far too much, at the absolute worst time. The boom is clearly over; now investors need to prepare for the bust.
Companies to watch
* Chesapeake Energy (NYSE: CHK): There are several oil and natural gas producers that are in deep financial distress. Chesapeake is one of them: the stock has lost 80 percent of its value in the past one year. Like so many others in the space, Chesapeake is also highly indebted. At the end of last quarter, it owed more than $10 billion in long-term debt. With natural gas prices near multi-year lows, it continues to lose enormous sums of money. Chesapeake lost $12.5 billion over just the first three quarters of 2015.
* Vanguard Natural Resources (NYSE: VNR): Vanguard is dangerously burning cash. Vanguard made two acquisitions last year, of LRR Energy and Eagle Rock Energy Partners in October. It now has $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.