the oil rally won’t save these companies

Ever since oil cratered to $26/barrel on February 11th, prices have steadily inched higher. West Texas Intermediate has now climbed into the $40/barrel range. Not surprisingly, energy stocks have kept pace, with many service companies and independent producers hitting year-to-date highs. Unfortunately for some energy firms, however, this recovery will probably be too little, too late.

Unlike other sectors, it is pretty easy to identify which energy companies will survive and which will likely file for bankruptcy. Because many energy firms have public debt, bond prices and bond yields can be extremely useful predictors of a company’s future stock price. The higher the yields, the stronger the likelihood a business is heading toward bankruptcy. Once bond yields surpass 50 percent, the chances of a default and reorganization approach near certainty.

Today there are a handful of energy companies with bonds yielding 50 percent or more. This includes Basic Energy (BAS), Gastar (GST), Energy 21 (EXXI), Exco Resources (XCO), Stone Energy (SGY), and W&T Offshore (WTI). Others, like Ultra Petroleum (UPL) and Linn Energy (LINE) have already missed interest payments on their debt, which is almost always a precursor to a bankruptcy filing and a zeroed out stock price.

The reason bond yields are such reliable indicators of financial distress is quite simple: buyers and sellers of corporate debt are not speculative day traders betting on long shots. They are mostly sophisticated, accounting-savvy institutional investors and hedge funds. They have to do be right more than they are wrong or they lose their jobs.

Conversely, investors in low priced stocks – especially retail investors – are often far less rigorous in their research and investing approach. Proof of this fact can be seen in the recent performance of the eight stocks I listed above. Despite the staggering yields on their bonds, almost all of them have seen their stock prices rally in recent weeks.

After three decades in money management I increasingly doubt whether John Q Public understands the implications of a Chapter 11 filing. I also wonder if senior managements (and their cheerleaders on Wall Street) instill a misguided fear of bankruptcy in workers and politicians. Why? Because financial elites know that bankruptcy always wipes out a stock price and hurts bond prices, as well. They also know that while bankruptcy reorganization rarely causes the widespread loss of jobs, it devastates the net worth of senior management, large investors, and sometimes Board members. In their eyes not all stakeholders are created equal.

The lesson is clear: before buying an energy company stock with public debt, investors should look at the yield and yield-to-maturity on that company’s bonds. If the yields are gigantic, bond investors are pricing a bankruptcy and reorganization into those bond prices. That means the stock price is probably going to zero, possibly within a few months. Unless oil prices rally quickly back to toward $90 or more, every energy stock mentioned above will almost certainly finish 2016 at or near zero.

3 thoughts on “the oil rally won’t save these companies

  1. Louis Stouch

    Just started reading your book and I love it.
    I remember GLM. I started at Kidder in October 87. A few years later, early/mid 90’s maybe, I started buying it around $3 (maybe $5, I didn’t keep records). Bought it up to $10’ish. Never forget the day a Prudential analyst came out with a Buy after it was already a double or so ($15 I think). A real thrill.
    Given your experience with the Fern bars, I would imagine you cleaned up shorting some of these ridiculous unicorn plays recently.
    Glad I found the website. Will definitely check out those 50% bond yield oil stocks for the short side. Thanks!

  2. Steve Yang

    I truly enjoyed reading the book. It tells the truth about how our financial system works –dysfunctionally. You are also a whistle blower, on the shenanigans perpetrated by Wall Street. Your writing reminds me of another book ‘Confessions of an EHM’ by Mr. Perkins.
    In other words money/greed at the highest level has corrupted our whole democratic system, with global consequences.

  3. Pingback: three ‘uninvestable’ industries for 2017 | the confessions of a contrarian investor

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