Slow Rebound In Oil May Trigger Another Bankruptcy Wave

Many investors have started to jump back into the oil sector in recent weeks based in large part on the slow upward grind in oil prices. With WTI and Brent both above $45 in recent trading, investors are starting to become optimistic and think perhaps the worst is over. That view is too short sighted.

Some investors seem to have forgotten 2015 already. Last year was a terrible year for energy investors, but many investors and even corporate officers may be deluding themselves in believing that if they simply hold on, the good times will return. The reality is that for many oil companies, the future is already written. In the last major oil bust of the 1980's, a little more than a quarter of oil companies went out of business. The same thing is going to happen again this time. And that means that investors and executives at oil companies showing the most signs of stress need to begin being realistic with themselves - some companies are already too far gone to save even if oil prices have finally bottomed.

None of this means that there aren't major opportunities in the oil patch, there are. Investors simply need to be very careful and selective to capture these opportunities.

In 2015, 42 oil companies filed for bankruptcy. This year will likely be even worse. In December of 2015, 11 percent of E&P companies defaulted on debts coming due versus just 0.5 percent earlier that year. Again, 2016 will be much worse. The problem is that even if oil prices start to rebound at this point, oil companies are still holding large amounts of debt. That debt will come due, and when it does, companies will only have two choices - pay it off in full or roll the debt over. These are the typical two choices that firms face of course, but normally rolling bonds over is straightforward. At this stage though, most oil companies are likely to find it nearly impossible to sell new bonds in order to retire the bonds coming due. With company's holding far too little cash to pay off their existing obligations, the only choice will be a bankruptcy filing.

Private equity firms like Blackstone are finally getting interested in the oil sector, but as is typical in the private equity space these firms are not going to be acting as white knights and coming to the rescue of distressed firms. Instead, they are likely to wait for bankruptcy filings and the cancellation of existing stock before buying assets out on the cheap. The unpleasant reality is that for many firms with debts coming due in the next year or two, unless they have exceptional operations, their stock may end up being worthless.

That does not mean the firms themselves will disappear of course. Take Hercules Offshore for instance. The firm declared bankruptcy early in the oil price collapse and emerged from Chapter 11 bankruptcy as a reorganized entity in November 2015. That hasn't stopped the pain for the company though - the stock price is off substantially since then, falling from just under $15 at exit to around $1 per share today. Clearly the market is pricing in a diminished future for HERO which may be justified given the $0.59 per share loss the firm saw in the third quarter on revenue of $74M versus $222M in the year earlier period. It is even possible the firm may end up back in bankruptcy as it has $450M in post-bankruptcy debt funded through a senior secured credit facility.

The broader point is that the pain in the oil industry is still coming and many firms will end up in bankruptcy. Yet that outcome by itself may not be enough to correct industry woes anytime soon. Just as Hercules Offshore emerged and is still operating, oil firms in the future may do the same and continue contributing to the glut in the markets. Ultimately, markets will correct the supply demand imbalance, but it will take time and the process of getting there will not be pleasant for investors.

To be clear, the slow rise in oil prices is good news for energy companies in general but much of that positive news has already been priced into many energy companies. Of the E&P companies that are publicly traded in the US though, 3 stand out as being worth special attention at current prices; EOG, CRZO, and NFX. All three companies are very strong firms, but their current stock price does not reflect that.

In each case, CRZO, NFX, and EOG all have attractive acreage in some of the best fields like Eagle Ford and the SCOOP. Each stock has held its own despite oil price decreases over the last year showing that there is a still a reservoir of investor support. Finally and most importantly, thanks to prudent hedging all three companies remain in a strong position financially and they have been able to keep control over their best assets while many weaker firms have been forced to sell top tier assets to stay afloat. As a result, EOG, CRZO, and NFX should all be poised to thrive if oil prices move even modestly higher between now and the end of the year.