A few months ago I traveled to Houston and wrote about the increasingly upbeat mood I encountered at the energy companies I visited there. I came away from that trip thinking that well-managed service and exploration firms might be attractive investments. Many had declined 40-60 percent in response to oil’s decline from $104 last summer to the low-$40s by late fall. As oil prices rose past $60 this spring, I suspected these stocks could eventually rally.
So much for that idea.
Earlier this year, Sabine Oil and Gas, Warren Resources, Quiksilver, and rig operator Hercules Offshore filed for bankruptcy. Last week, Samson Resources and Sandridge moved close to restructurings, as well. Other public energy companies close to bankruptcy include Halcon Resources, Energy 21, Swift Energy, Comstock Resources, Goodrich Petroleum, and EV Energy Partners, LP. The list goes on and on, and it’s likely to grow.
This fail parade is not solely due to low oil prices, however. It’s the predictable result of a problem endemic to the energy business: an absolute inability to say no to Wall Street debt financing. Borrowing money from Wall Street is a crippling addiction that has afflicted this industry for as long as I’ve been studying it. Until oil and gas executives learn to follow Nancy Reagan’s advice and Just Say No when Goldman Sachs and other big brokerages come calling with fee-rich debt deals, they will continue to drill their companies into oblivion.
As a general rule, the grander the ambition, the greater the balance sheet leverage—and nobody outdoes the energy industry when it comes to grand ambition. The vast majority of publicly traded energy companies incur capital outlays in excess of their annual cash flows. Wall Street happily encourages this destructive behavior by arranging one bond offering after another during industry uptrends. Why managements and Boards approve these potentially disastrous financings is simple: overconfidence. They convince themselves that they will grow faster than their peers, so they eagerly borrow and outspend their cash flows and rarely, if ever, give cash back to investors via quarterly dividends and/or share buybacks. Of course, this doesn’t stop the same Wall Street firms who arrange all that borrowing from covering and—more often than not—recommending their stocks.
A few weeks ago I met the chief financial officer of Denver oil firm Bill Barrett Corp (BBG). His stock was $9 then, down from the mid-$30s in 2013. It’s now below $5. Not surprisingly, Barrett has public debt, courtesy of Wall Street investment banks, which in a worst-case environment could tip the firm into a restructuring. This is a business with $472 million in revenues last year, and yet a staggering 18 Wall Street analysts cover it. Gee, I wonder why. Compare that to one of my favorite non-energy stocks of late, Calavo Growers (CVGW), a company with $1 billion in annual revenues and virtually no debt. For most of its history, Calavo has been followed by no more than three Wall Street analysts. A fourth recently initiated coverage.
The balance sheets of most Silicon Valley firms are the polar opposite of energy operators. Apple, Google, Microsoft and most software/internet companies have loads of cash and little, if any, debt. In recent years many Silicon Valley companies have started quarterly dividends and buybacks, instead of throwing their full annual cash flows (or more) into R&D efforts.
Not all energy managements fell prey to the lure of borrowed money. Houston-based Vaalco Energy (EGY), which explores and produces offshore in West Africa, has almost no debt and nearly a dollar a share in cash. Vaalco’s stock has declined with the group, and closed at $1.50 on Monday vs. $9 one year ago. If oil prices continue to suffer, investing in Vaalco or similar, debt-free companies probably won’t bring monster returns anytime soon. But at least you can sleep well at night knowing you’re not going to wake up to a bankruptcy filing and a zeroed out stock price.