If the history of the so-called "Great Recession" of 2008-9 is to be believed, while the current carnage in the energy space will negatively impact a lot of people, both investors and those in the industry, it will create some tremendous opportunities for those with the ability to take big risks. At some point, this too shall pass and when it does, it will become clear that some stocks were massively oversold on the way down.
That doesn't mean, however, that investors should be rushing in to buy depressed energy stocks willy-nilly. The collapse in oil prices will have some real, long-term consequences that could be dire for some companies.
The problem is not just that crude prices are being hit at the same time as the coronavirus shutdown kills demand. It is also that a lot of energy companies came into this with massive debt loads. That presents an obvious, immediate short-term problem of servicing the debt as revenues dry up, but there is another, bigger, long-term problem that for many could prove to be an existential threat.
The security for those loans is usually oil and gas reserves, and those reserves are worth a lot less now than they were just a few months ago. In the case of oil, the value of the loan collateral has dropped by over sixty percent in three months. Natural gas holdings have halved in value since November of last year.
In theory, that doesn't really matter that much to the borrowers until the loans come due and need to be refinanced…
If the history of the so-called "Great Recession" of 2008-9 is to be believed, while the current carnage in the energy space will negatively impact a lot of people, both investors and those in the industry, it will create some tremendous opportunities for those with the ability to take big risks. At some point, this too shall pass and when it does, it will become clear that some stocks were massively oversold on the way down.
That doesn't mean, however, that investors should be rushing in to buy depressed energy stocks willy-nilly. The collapse in oil prices will have some real, long-term consequences that could be dire for some companies.
The problem is not just that crude prices are being hit at the same time as the coronavirus shutdown kills demand. It is also that a lot of energy companies came into this with massive debt loads. That presents an obvious, immediate short-term problem of servicing the debt as revenues dry up, but there is another, bigger, long-term problem that for many could prove to be an existential threat.
The security for those loans is usually oil and gas reserves, and those reserves are worth a lot less now than they were just a few months ago. In the case of oil, the value of the loan collateral has dropped by over sixty percent in three months. Natural gas holdings have halved in value since November of last year.
In theory, that doesn't really matter that much to the borrowers until the loans come due and need to be refinanced but it still has the feel of a ticking time bomb for some smaller energy companies. The problem for investors in energy is that it means that even after the current crazy times are behind us, there will still be companies facing problems.
Of course, that wouldn't be the case were prices to recover rapidly, but that looks unlikely.
It is not that oil can't or won't recover, it's just that even a major retracement will take time and could easily still leave crude at significantly lower levels than it was when the existing loans were arranged. The situation with natural gas is, if anything, even worse.
The recent drop there was part of a longer-term steady but large decline in prices, suggesting that even if a cure and vaccine for coronavirus were found tomorrow, poor old natty would still be depressed.
None of this means that investors shouldn't be looking to take advantage of the opportunities out there, just that they should be careful when they do.
The obvious choices are the big, multinational, integrated firms. They generally have solid balance sheets and have decades, in some cases more than a century of experience in navigating shocks to the market and crises. Throw in the double-digit dividend yields available in some cases and using some available funds to pick up big, stable companies at bargain prices on dips is really a no-brainer.
That said, though, the real money is to be made by finding smaller companies that have been caught up in the selling despite not fitting the profile of companies with liquidity problems in their foreseeable future. In that context, something like Diamondback Energy (FANG), with a debt to equity ratio of around 36 and a current ratio of 0.69, would be preferred over something like Apache (APA) with over 174 debt/equity and a current ratio over 1.
Admittedly, FANG is down "only" 70% from this year's high versus an 86% drop for APA, which may lead some to see the better opportunity in Apache. However, when the liquidity situation and risk of both are considered, it is clear that FANG is the better investment.
For those looking to take advantage of this unprecedented collapse in energy stocks, there are a couple of things to consider beyond just what is "cheap". Liquidity, solvency even, is going to be a real issue going forward, so balance sheet strength going into the crisis is important. Other factors, like cash flow and margins that give an indication of how quickly a return to profitability is possible should also be considered.
In short, at times like this it is worth remembering that price and value are related, but not the same thing. I don't mind risk, and nor should you; it is part of investing. But, the risk of total loss in an investment should be avoided if possible, so care and research are needed if you are looking to buy.
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