With Energy XXI (EXXI) filing for Chapter 11 bankruptcy, I think now is an appropriate time to summarize key takeaways from the filing itself; and really, I'm referencing key risk management takeaways to be had from observing Energy XXI in the run-up to the actual bankruptcy filing. As strange as it might seem, especially if this is an investor first (READ: the first bankruptcy experienced by any particular investor), Energy XXI's bankruptcy is quite "normal" for the process and "normal" for its particular space (energy). Here are a few key takeaways I'd like to note for those that might have other "stressed" positions within their book or for those thinking of adding some stressed exposure to their book on an ongoing basis.
To be clear, I'll be keeping things very "high level" within this note and nothing within this note is entirely inclusive of all relevant information; out of respect for those reading this note both are being done to keep this note at a readable length.
If It Sounds Too Good To Be True…
In reviewing the "social commentary" surrounding Energy XXI's situation - including quite a bit of this right here at Seeking Alpha (via the comments section of several of my prior notes on Energy XXI) - one thing was a constant: those long exposure were far too optimistic about the restructuring/recovery prospects of Energy XXI (and it seems the level of depth of being underwater directly correlated with the level of misplaced optimism). In fact, many of the bull cases - if you, like I did, choose to believe that the commentary was genuine - directly flew in the face of clearly outlined covenants within different (oftentimes several) cap structure vehicles.
A few examples:
"A buyout is coming…": All relevant cap structure vehicles have "change of control" covenants that reprice the vehicles to "par" (or 100 cents on the dollar) upon a change of control. The "adjusted" enterprise value of the E&P - Energy XXI in this instance - isn't the "change of control" cost; this often changes the feasibility (as it did with Energy XXI) of a "buyout" taking place. More on this later from me but I'll leave this right here.
"Major asset sales/cash raising efforts via divestitures are coming…": Granted I never heard this bull thesis phrased this way, this was an often promoted thesis I heard from bullish investors. As with the above bull thesis, nearly all relevant cap structure vehicles (all of the senior cap structure vehicles) hold covenants that restrict 1) the sale of assets and 2) the sale of assets at less than "fair value" pricing; by the way, "fair value" determination would have forced the Board of Directors to take on legal responsibility for the transaction (something that adds a "hurdle" to this thesis playing out).
"Energy XXI can buy back all of its debt at pennies on the dollar and is doing this currently…": Again staying with the theme of the above, all relevant cap structure vehicles (again most importantly the most senior vehicles) contain prohibitive/restrictive buyback covenants (some of these were more relaxed if these purchases were being done via equity raise). Yes, it's true that Energy XXI did buy back significant amounts of debt - approaching limits within the covenant schedules of relevant cap structure vehicles - but this was only in an effort to lubricate its "prepack" bankruptcy talks (in my speculation, I have no direct knowledge this was the case but my experience in this arena leads me to believe this). How this works mechanistically is much too complex to explain in a high level note, so I'll pass on the opportunity here, but just know that this is NOT an uncommon way to lubricate prepack talks. The general summary here though, again covenants did this bull-thesis in; the "buyback" thesis was never any more realistic than the maximums allowed within the covenants.
Now, call this blind optimism what you will, and I'd like to call it pure naivety or a simple absence of the necessary knowledge, but it was costly to those operating, professing, and/or perpetuating the misinformation. The bottom line here, if you don't take the time, can't, are unable, or are unwilling to review, analyze, and digest entirely the covenant schedules of all relevant cap structure vehicles you probably should simply avoid the investment. In general though, if "it" sounds too good to be true - the turnaround prospects of an investment trading in "penny stock" pricing ranges with debt vehicles trading in the same ranges - it most likely is too good to be true. Caveat Emptor.
Companies Can Be Wrong, Often Are, and It's Nearly Impossible To Hold Them Accountable…
This is how it appears; I've found a direct correlation between companies' inabilities to forecast prior to becoming "stressed" and their collective inabilities to forecast while being stressed. Energy XXI's April 14, 2016, released "Project Bluewater" creditor presentation (SEE: EXXI 8-K filing) shows two very important divergences between Energy XXI internal and publicly stated projections regarding 1) cash and cash equivalents (by duration) and 2) forecasted oil pricing and those made by restructuring firm PJT. Energy XXI has long forecasted (based on my analysis of its financial projections, its operational spend structuring, its comments made during conference presentations and conference call presentations, etc.) ~$50 oil; PJT provided 3Q/FY16 average strip pricing of $32.09, 4Q/FY16 average strip pricing of $39.62 and 1H/FY17 average strip pricing of $42.11. All materially different (and far more accurate to this point) than projections made by Energy XXI:
With Energy XXI being a commodity producer, when commodity pricing inputs (inclusive of forecasts) are wrong the results can be (and did show to be) catastrophic. These catastrophic results are exacerbated by the public voicing (via all of the above listed "backed out" statements of pricing) of such inabilities to forecast (by management often). Those choosing to trust management/company statements and/or those meeting any of the above listed failures of due diligence can be financially devastated by reliance on such inaccuracies. A quick review of Energy XXI social activity shows this was the case in this particular situation, sadly.
Another area of missed forecasting - this one equally as egregious as the above - was in Energy XXI's inability to correctly forecast liquidity (as a function of having a "garbage in" input from its commodity pricing forecasts). Liquidity, for those following along, is the lifeblood of E&Ps. Energy XXI's liquidity expectations, which it should be noted likely were the basis of a terribly wasteful and misled liabilities reduction program, differed greatly (again) from PJT's more accurate forecasting. Again, this was a gross (without making any accusations) misleading of expectations:
But what can be done about such inaccurate forecasting? Absolutely nothing. As I've explained to many within my consult - often on the front-end of onboarding, during our more "educational" meetings - it's nearly impossible to prove out a subjective claim (like that of a forecast) in court. Again, this is why I urge all investors to do deep level due diligence, to pay somebody to do this, or to avoid these types of stressed investments. Proving out subjective claims is NOT a bankruptcy "bull thesis" for those thinking of forming an equity committee. Again, please do your due diligence when walking on a razor's edge.
Prepack Talks Start Long Before You Think They Do…
I'll keep this section short because this is the "trust me" portion of this note and as is said on Wall Street, "there are no trust me stories - only show me stories." That said, I've participated in many a conversation regarding so-called "strategic alternatives" - some have been well-publicized while some haven't. These talks start long before it appears the enterprise (E&P) might appear to need to have "the talk" and long, long before it's made public that strategic alternatives are being considered.
We now know that Energy XXI was having prepack talks dating back to at least March 3, 2016. Some that I've talked to with industry knowledge claim that Energy XXI was reaching out to parties as early as December (this claim should be considered anecdotal and unsubstantiated). In any case though, the general point of this final takeaway is that the second an intercept "point of no return" is breached (this point is hard to determine but some firms are in the business of determining this and do it with accuracy) the conversation - regardless of what is being publicly led on- immediately moves to "doing what's best" for the New Boss. Who's that "new boss"? The top of the cap structure of course. The guys owning and in charge of all those restrictive covenants outlined in the introduction of this note; covenants put in place to insure that the company - "their" company - can't be gutted prior to "their" taking control.
My condolences to those who lost money in Energy XXI and my best wishes to everybody else.
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.
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