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.