Swift Energy (OTCPK:SFYWQ) had the symbol SFYW prior to it becoming the 40th oil company to declare bankruptcy in 2015 on December 31, 2015. Before it was delisted from the Stock exchange, it had the symbol SFY. Sandridge Energy (OTCPK:SDOC) was SD, prior to its delisting from the New York Stock exchange on January 6, 2016, has so far avoided bankruptcy. Both the shares and bonds of SFYWQ and SDOC trade at severely depressed prices. They also might be interesting ways to bet on an eventual rebound in oil prices. They differ in terms of their approach to waiting out the collapse in oil prices and there are specific risks and potentials in both approaches that SFYWQ and SDOC are effectively taking.
The difference in the capital structure between the two has led to their differing paths. SFYWQ filed a prepackaged bankruptcy in which a majority of SFYWQ bondholders have agreed to support a reorganization plan that allows the existing SFYWQ shareholders to maintain 4% of the equity in the reorganized company. This is interesting since the last 10-Q report (September 30, 2015) indicates about $1 billion in assets for SFYWQ, after having been written down from $2 billion during 2015 as oil prices collapsed.
As the reorganization plan calls for all of the bond debt to be converted into 96% of the equity that could imply a book value close to $1 billion. If the book value were an accurate measure of true value, 4% of the equity would be $40 million. However, at $0.13, the 44,547,481 shares outstanding are only valued at $5.79 million. The bonds of SFYWQ are trading around 10% of face value, roughly in line with what the current stock price implies.
In a November 2015 presentation, SFYWQ reported year-end 2014 proven reserves of 194 million barrels of oil equivalents. Using the standard PV-10 methodology whereby the present value of estimated future oil and gas revenues are calculated, net of estimated direct expenses, discounted at an annual discount rate of 10%, at year-end 2014, SFYWQ had a reserve base of $1.94 billion net of $85.4 million in asset retirement obligations. This was computed using prices of $93.64 for oil, $4.32 per Mcf for natural gas and $33 per barrel for natural gas liquids. Prices have deteriorated sharply since then. However, even using current prices, the reserve base is worth hundreds of $millions. Were prices to recover to year-end 2014 levels, SFYWQ would be an entity with $2 billion in proven reserves and no bond debt.
SDOC plans to wait out the recovery in the oil and gas markets without resorting to bankruptcy. Needless to say, such plans are often subject to revision. SDOC does not have significant bond maturities in the next few years. In contrast, the large June 1, 2017 SFYWQ bond maturity made a bankruptcy filing inevitable. SDOC reported $790 million in cash in their September 30, 2015 10-Q. SDOC was able to issue $1.25 billion in senior secured notes with an interest rate of 8.75% maturing June 1, 2020. This was one of the last large issuance from an oil company, in that size range, before such companies were shut out of the credit markets. This well-timed borrowing gives SDOC a potential chance to avoid bankruptcy for a few years.
Unlike SFYWQ, a bankruptcy filing by SDOC would result in no recovery for common shareholders. The above holders of the above mentioned $1.25 billion in senior secured notes would most likely put in a credit bid and take all of the assets. Even if that did not happen, the unsecured bondholders and creditors would come before the common shareholders. Making the prospect for any recovery even more remote for SDOC common shareholders, is the existence of two convertible preferred issues that come before SDOC common shareholders.
There is a $265 million 8.5% convertible perpetual preferred stock (SDRXP) now trading at 2.75% of it $100 face value. There is also a $300 million 7.0% convertible perpetual preferred stock (SDRXN) ) now trading at 1.5% of it $100 face value. SDOC has the right to pay the dividends on the convertible perpetual preferred stock in common shares of SDOC rather than cash. In a somewhat bizarre move, SDOC suspended the dividend on SDRXN in November 2015 even though they could have paid it in shares with no outlay of cash. The SDRXN dividend date has not occurred yet, but it will probably be suspended as well.
Clearly, any securities issued by SFYWQ or SDOC are highly speculative. With SDOC, the question is how long it can hold out waiting for oil and gas prices to improve. Dallas Salazar has a number of Seeking Alpha articles beginning with: SandRidge Energy - 'Caveat Emptor, Carpe Diem' in which he has a long list of operational and structural changes that he asserts would greatly enhance the probability of SDOC surviving. In that article, he indicates that SDOC management has enacted some but not all of his recommendations. He said, "SandRidge as of late has done an excellent job in making progress into what would have been my recommendations for destressing its model."
If oil and gas prices never recover, SDOC is clearly doomed. There is also an issue involving SDOC refusing to comply with the Oklahoma authorities' request that SDOC curtail injecting waste water into the ground. Those authorities claim that there is scientific evidence that says waste water injection is causing the increase in Oklahoma earthquakes.
There are two schools of thought regarding the future direction of oil prices. The geopolitical approach is that major producers such as Saudi Arabia and Russia will keep flooding the world oil market precluding any recovery in oil prices in the foreseeable future. The other approach regarding the future direction of oil prices is based on fact that all oil and gas production in any period is the result of previous exploration and production capital expenditures. Since all oil wells deplete, albeit at widely varying rates, no drilling today eventually results in no oil at some future date. This approach is taken in our article: Will Oil Production Fall Off A Cliff? In that article, we utilize macro models to relate world oil prices to exploration and production capital expenditures. We then utilize macro models to relate world exploration and production capital expenditures to oil supply.
The word cliff with regard to future oil supply refers to a situation where the decline in oil production resulting from the ongoing reduction of exploration and production capital expenditures will not significantly impact total supply for a while due to the enormous amount of oil stockpiled in storage tanks, ships and drilled but uncompleted wells. In the way that cartoon characters like Wile E. Coyote and the Road Runner run off a cliff and seem not to fall for a while, but then drop precipitously, when the stockpiled oil runs out, the reduced production will cause effective total supply to plummet.
There was an old rule of thumb that it takes $20 of exploration and production capital expenditures to produce a barrel of oil. Like all such generalizations, the actual relationship between exploration and production capital expenditures to barrel of oils produced varies greatly. However, by most accounts, the decline in oil prices in recent years has reduced exploration and production capital expenditures by at least $200 billion below what would have been the case, if oil prices had not declined. Land based oil drilling rigs in the U.S. have fallen from a peak of 1609 in November 2014 to about 550 at the end of 2015. Clearly, in order for any oil to be produced an oil rig must first drill a well. Thus, oil production in one period is a function of exploration and production capital expenditures in prior periods.
It is true that many entities are producing oil flat out in order to offset the income lost by the lower prices. These range from cash-strapped struggling companies such as SFYWQ and SDOC to state owned or controlled entities in Russia and the OPEC countries. However, cash flow can be increased not only by increasing production but also from deferring capital expenditures including maintenance. Oil producers now producing flat out cannot increase output without spending money on exploration and production capital expenditures. In some cases, oil prices are now so low that production from existing facilities is being curtailed. This has occurred in the tar sand project in Canada and some stripper wells elsewhere.
Like monetary policy affects the economy, exploration and production capital expenditures influences oil production with long and variable lags. At one extreme, seismic mapping of undersea geological formations can be an expenditure that eventually leads oil production ten or more years later. Spending money on hydraulic fracturing a well can result in production within a few weeks. Presumably, it is the capital expenditures that hold the promise of returns many years in the future, which are being cut first while expenditures, which are necessary to prevent sharp declines in production next week are the last to be cut.
The rate at which oil wells deplete varies even more than the lags between oil production and the exploration and production capital expenditures that were responsible for the production. Some oil wells have been producing for over 100 years. At the other extreme, wells involving shale and hydraulic fracturing typically deplete around 60% per year in the first few years of production. With such divergent relationships between exploration and production capital expenditures and when the resulting oil well produce and eventually deplete, estimates of when the current reduction in exploration and production capital expenditures will impact supply vary dramatically.
One dramatic headline says "Oil Bust Kills Off 19 Million Barrels Per Day Of Future Oil Production" which quotes David Pursell, managing director of macro research investment bank Tudor, Pickering, Holt & Co. as saying "By not sanctioning projects today, you're putting a hole in production in 2017, 2018 and 2019 - potentially a big hole," To come up with the alarming 19 Million Barrels Per Day figure, they include an assumption that Canada's oil sands are expected to see 3 million barrels of oil production per day less than what it previously anticipated and Iraq will fail to realize 5 million barrels per day of production. With oil production at 93 million barrels per day in 2014, a reduction of 19 million barrels per day would severely impact oil prices given the inelasticity of demand for oil.
The Tudor, Pickering, Holt & Co. report does concede that higher oil prices could reinstate the 150 oil projects, which account for about 125 billion barrels of oil that they say oil companies have either cancelled or suspended final investment decisions on. The drilled but uncompleted wells clearly represent oil supply that will reappear when prices increase.
The potential production from incomplete wells is estimated to be about 500,000 per day and is growing. However, the phenomena of oil being "stored" in drilled but uncompleted wells is somewhat of a unique situation that may be coming to an end. It is unlikely that the economics would support starting a new exploration program today with the intent to drill wells but not complete them until prices improve. The present large number of drilled but uncompleted wells is a result of the drastic decline in oil prices catching many exploration and production companies with contracts and commitments that would have called for high cancellation and severance costs that would have been incurred if drilling would have been halted as soon as prices declined.
As these contracts and commitments run off there will be little incentive to drill wells and not complete them. It was the very quick payback periods for shale wells with hydraulic fracturing that enabled drilling programs to look economically very attractive in terms of internal rates of return and net present value calculations. These calculations enabled many drillers to take on large debts that are now leading to many bankruptcies. It also makes no economic sense to drill wells and not complete them in any areas of the world that are not as politically stable as the United States where the passage of time increases expropriation and other political risks. There are also some circumstances where oil leases must eventually produce in order to be held by production to prevent the leases from expiring.
In order to make some sense out of the conflicting issues regarding when oil supply might drop precipitously, we attempted to make macro models relating oil production to prior level of exploration and production capital expenditures. There are a number of challenges in attempting to develop such models. Oil production is measured in physical barrels while exploration and production capital expenditures are measured in US$. To address that issue, we used the producer price index for "Oil and gas field machinery and equipment manufacturing" as a proxy for a deflator for exploration and production capital expenditures. Obviously, there are many components of exploration and production capital expenditures that do not directly involve oil and gas field machinery and equipment, but assuming that prices for those other expenditures moved roughly in line with the producer price index for oil and gas field machinery and equipment is not unreasonable.
Our macro models indicate that the long run supply curve quantity for oil at a price of $40 is about 80 million barrels per day. Thus, $40 is an unsustainable price. World demand is about 95 million barrels per day. This is not considering any increase in fuel consumption that may result from lower prices. The decline in world exploration and production capital expenditures so far, predicted for 2016 alone are projected by our models to reduce oil output by 7.1 million barrels per day
The 7.1 million barrels per day is less alarming than the 19 million barrels per day figure. However, with a modest increase in world oil demand, which is generally assumed, any reduction in oil production near 7.1 million barrels per day would swamp the production from drilled but uncompleted wells and quickly exhaust all stockpiled supplies thus having total world oil supply effectively falling off the proverbial cliff. The question remains how long it would take exploration and production capital expenditures to ramp up again in response to or in anticipation of the oil price increases that falling off the supply cliff would entail in an inelastic oil market.
There are two outlier scenarios, which make speculating in securities issued by SFYWQ and SDOC even more like gambling. One thing that could turn around the oil supply situation quickly would be armed conflict involving oil producers. Traditionally, when a country's people are suffering from reduced economic conditions authoritarian regimes and despots turn to military aggression to divert the attention of the populace from their economic woes. The recent hostility involving Saudi Arabia and Iran could lead to supply disruptions. Russia could take a more belligerent stance as well. In a related scenario, Iran could realize how little it will receive net after expenses with oil prices this low from the relaxation in sanctions and decide that keeping their nuclear weapons capability is preferable to the recently signed agreement.
In the other direction, there are the scenarios that a severe worldwide economic contraction or a technological leap could cause world oil demand to plummet. Every day, I receive emails claiming that some new energy technology will put Saudi Arabia out of business. So far, alternative fuels have been noncompetitive with petroleum. However, that could change.
With the securities of SFYWQ and SDOC, there is tremendous risk and potential reward.
Disclosure: I am/we are long SFYWQ, SDRXP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I own bonds in both SFYWQ and SDOC.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.