First, let me say that I am actively doing due diligence on many energy names to try and ascertain if they might be good plays for the cyclical bottom in energy which I expect. It was in the course of this research that I increasingly started to believe that industry-wide management has been acting a little dumb.
First, let me say this: the current energy price crash can be said to have started around mid-2014. While natural gas has been weak for longer, back then it even traded at a decent and profitable $4/mmBTU. Crude, for its part, went for over $100/barrel. And that's WTI crude, which was trading at a discount to Brent at the time.
From that moment on, things started going pear-shaped (meaning they started going wrong). And they started going wrong in such a way that it was obvious the market was oversupplied and would remain so for a while - given that production both for crude and natural gas was still growing. Crude got cut in less than half before 2014 was over, and natural gas went down to less than $3/mmBTU, where things also start looking ugly for E&P companies.
This means that today's ongoing crash started 1-1.5 years ago. Right at the start, it was obvious that financing would become more difficult for nearly all E&P companies except the largest - the chart below shows that yield on energy high-yield corporates sky-rocketed immediately. So right at the start, there was a strong incentive to quickly reduce capex.
You see, all of the independent E&P companies have a problem: when they drill to increase production, they are all FCF (Free Cash Flow) negative. This is so because the well costs come upfront, and then the well will supposedly generate cash until it pays itself and provides a return. This basic reality is the reason why it seems to me that the management of many of the energy stocks I'm looking at seems rather dumb. For instance:
- Chesapeake (NYSE:CHK), 9 months to September 30, 2015. Cash provided by operating activities: $1.06 billion. Capex: $2.70 billion. CHK even went further and actually still acquired properties to the tune of $400 million. Result: negative FCF.
- Anadarko Petroleum Corporation (NYSE:APC), 9 months to September 30, 2015. Cash provided by operating activities: $3.08 billion (I'm ignoring a contingent liability here). Capex: $4.90 billion. Result: negative FCF.
- Ultra Petroleum (NYSE:UPL), 9 months to September 30, 2015. Cash provided by operating activities: $411 million (of which a significant amount came from a unrealized gain in derivatives - $85 million and a drop in accounts receivable - $50 million). Capex: $391 million. Result: very slightly positive if we ignore the two non-recurring events inflating operating cash flow, negative otherwise.
- Southwestern Energy (NYSE:SWN), 9 months to September 30, 2015. Cash provided by operating activities: $1.23 billion. Capex: $1.39 billion, plus SWN saw it fit to deploy $582 million in an acquisition. Result: negative FCF.
See the pattern here? Every one of these companies saw no problem in keeping their drilling activity at levels which assured negative FCF. Indeed, all their presentations read somewhere along the lines:
- Here's how we will drill us into a hole (lots and lots of slides about the opportunity to drill everywhere). Look at how much faster drilling us into a hole is nowadays (statistics about the time to completion)!
These seem like presentations from 2 years ago. But they are from late 2015, even from December.
Now, why is this pattern troubling? It's not just that the market they sell into would come into balance easier if everyone invested less. It's also that negative FCF has a curious consequence: you need more financing (more money).
And That Is Dumb
Needing more financing and not running the business for positive FCF as soon as you see a problem (that won't go away instantly) is dumb in this and many other markets. This is so because of the point of view of the banker (or any other financing entity) doing the financing. It goes like this:
- First, he can't lend you more money. He can't because as soon as the fundamentals of the sector you're in deteriorate significantly, his exposure to the sector will start flashing red saying "you need to keep this under control" (as in, "you can't lend any more money into this sector and you need to reduce exposure if you can").
- Second, he doesn't want to lend you more money. It's not just that he can't. You see, as soon as your sector goes into the toilet, it's not just the stock of your negative-FCF company which gets sold. Your debt also gets sold, hard. Everybody wants less exposure. And with that selling, lower prices come. And with lower prices, come higher yields (look at the chart I posted on energy yields - those blown out well before 2014 was even over). Now, why in God's name would your bank or anyone else lend you more money in reasonable terms, if he can "lend" you the money on better terms just by buying your already-existing debt? The answer is: he won't want to give you more money. If he wants exposure to you, he'll buy your quoted debt instead.
There are exceptions, like issuing more debt on better seniority terms which push whatever debt already exists lower. Or lending against collateral (secured loans). But alas, those also pressure your existing debt lower and are already desperate measures to boot. Why would you keep your negative FCF flowing if you need to take desperate measures to do so? That's dumb.
Now here's what your banker, even if unwillingly, can do. He can roll over your existing debt! Because if he doesn't, he gets stuck with all those ugly assets in an imploding sector. Plus it looks good on his book, that his debt isn't all going pear-shaped like your God-forsaken sector. Were that to happen, and his own bank would then look as good as your negative-FCF-heading-towards-bankruptcy-business!
So there you have it. That he can do. He can roll over your debt. He just can't and doesn't want to lend you any more money.
What do you need so that rolling over existing debt is enough, and you don't have to borrow additional amounts? You just need positive FCF! Then, whatever amounts come due will just need to be substituted by the same or lower amounts.
Thus, as long as you are in this negative FCF treadmill, you're heading to the court steps. But if you pull back hard, you're just heading to some difficult talks with your banker. So why did all of those companies decide to continue to run their businesses at a negative FCF all throughout 2015? It's dumb, like I said.*
Moreover, the oil and natural gas that's in the ground doesn't run away. If you don't drill it today, it will still be there tomorrow. So, again, it's dumb to risk the entire business just so you can drill it a bit sooner.
There are two implications from this:
- First, it's knowledge you can use in similar situations. For some reason, every cyclical business but the very best managed seems to be run like this, burning money even when things are already visibly turning ugly. So don't trust that any business will do the right thing and cut back to a positive FCF position when expansion is threatened. But do value higher those that are sensible enough, because those are likely to be the survivors.
- Second, and this has to do with the ongoing search for companies better suited to a cyclical turnaround: it's important to notice if the candidates you're choosing braked soon enough and are now in a position not to need additional financing. Obviously, you also have to look at debt maturities and stuff. Here it might be different if the debt maturity coming up is a bond or a bank loan. If a bond matures, you'd need someone else to take on the risk and that's nearly the same as needing more financing. If a bank loan matures, you can go and talk with the same bank(s) and the risk of default is lower.
As we know, these are the darkest of times to be trying to pick companies in the energy sector. But that's how it always looks at cyclical bottoms. It seems like everyone will go bankrupt. If only they'd been less dumb one year ago…
* There's a possible excuse due to commitments to keep leases, rigs, take-or-pay agreements on transportation or gathering systems, etc. Then the dumbness might actually be on those agreements.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.