This week, Energy XXI (NASDAQ:EXXI) announced that it had filed for bankruptcy. So the curtain is dropping on the current structure of the company. Equity investors and unsecured holders will lose all of their investment. Despite the efforts of management, negotiations yielded very little for many classes of stakeholders. For as much as there was a discussion in many previous articles about creditor agreement, the very interesting conclusion in this case is the lack of agreements. Only about 63% of the second lien secured creditors agree. There is no agreement with the banks and no agreement with the unsecured creditors. This happened despite one delayed payment that was made and despite discussions with lenders for more than thirty days before this.
Back in July, it was noted in a previous article that company management was discussing with some major unsecured holders a possible solution to the company's debt problems. Yet it was clear this week that the company could not come to agreement with all of the unsecured holders in a way sufficient to avoid bankruptcy. For all those who are holding out hope that Sandridge Energy (OTCPK:SDOC), Halcon Resources (NYSE:HK), Linn Energy (NASDAQ:LINE), and others in a similar situation, this result should be throwing cold water on those hopes (to say the least).
The company only has an agreement with one set of lenders and that was the secured ones. Plus many articles have noted that for voluntary reorganizations, agreement is needed for 90% or higher of each group. From above, the company was nowhere near that amount in any class when it filed. Management even took more than thirty days from the first payment delay to the bankruptcy filing. So clearly, investors hoping for the other companies to avoid bankruptcy are hoping for a chance that is probably around 1% or less.
At least one contributor, Richard Lejeune, has acknowledged both in comments to articles and in his own articles that expenses tend to come out of the woodwork in bankruptcy filings. He has a lot of company agreeing with that position. Plus management will get the first try at reorganizing the company. Investors should expect a debtor in possession loan that will be superior to all claims, even the claims of the banks with the first lien. So as crazy as it seems that all the unsecured bonds will be wiped out with no claims, until the bankruptcy process has run its course, and management has had its tries at reorganizing the company, the course chosen by management may not be all that unreasonable.
Next are the cost issues. As noted previously, the company had a fair amount of success dropping costs. However, oil and gas prices have not cooperated, and the outlook for those prices has deteriorated as more and more companies announce successes at dropping operating costs, increasing production, and decreasing decline rates. Oil supply has persisted stubbornly at price levels unimaginable just six months ago, and may well persist more than forecasted in the future. The production improvements show no sign of stopping. So while management was meeting its cost cutting goals, and may have even exceeded them, the oil price dropped faster, and stayed lower. In short this company became less profitable even with hedges despite its operating success.
With cash flow drying up even with the help from the hedging program, investors would be wise to wait on the sidelines for this company to show an appropriate positive track record before jumping at a second investment chance in this company. The stock will probably have high reward potential, but with production costs dropping in the industry, and the commodity price outlook fuzzy at best, the company could well emerge from bankruptcy having to play "catch-up" with the rest of the industry. Financing could well be adequate for a year or so, but the company could still be losing money and have a lot of work to do. Even though the headlines claim that OPEC is at war with the shale industry, this over-leveraged company got shot and may not recover even after bankruptcy.
The other cost issue was the effect of all that debt. The company leveraged up during the good times, and then had to pay the debt back with commodity prices at one third or less of the highest price. Obviously the strategy did not work. Plus the debt cost at the start of the year was $19 BOE which turned a profitable situation into an unprofitable situation. The company needed to not only be a low cost leader in the industry, it had to be a low cost leader by a mile to handle all that debt. In a commodity industry, such a situation rarely happens and should give investors pause for more contemplation when investing in heavily leveraged companies in the future. Those high rewards from this type of speculation are just not as easy to achieve as it looks like. All that debt clearly put the company at a serious competitive disadvantage that only a miracle would cure.
Investing in financially leveraged companies appears to be exciting for a number of reasons, but especially the imagined outsized returns that these companies supposedly offer. However, to use a baseball analogy, the team that hits the most home runs is usually the team that hits the most singles and doubles consistently. Lucky teams are a substantially lower percentage. So usually the greatest returns on average come from the consistent companies that produce gains year-in and year-out. Usually they achieve those returns with much less risk than Energy XXI. For the average investor that has a job and family, and invests in the stock market, those consistent companies have investor requirements more suited to that average situation. The highly leveraged companies require an agility and expertise that many investors don't have, but wish they did. So the outsized speculative returns don't materialize. Even though once in a while there is that giant return so alluring that the market and investors want to try and duplicate that return. This is an allure that is similar to lottery tickets, that on average lose money, but the one time the investor wins overcomes the average.
The leverage that the market needs to pay more attention to is operating leverage. Many of the financially sound companies such as Murphy Oil (NYSE:MUR), Granite Oil (OTCQX:GXOCF), and others have the ability to increase production rapidly, increase profits rapidly as a result, and have the ability to wait out delays in commodity price increases. So timing forecast errors won't doom the investment. Such companies have produced outsized returns that investors dream of for the financially leveraged companies even if that returns happens a little more slowly.
So the curtain is falling on the current Energy XXI situation. But with the second lien investors inheriting all of the equity of the company in the reorganization, this company's stock will be available for trading again in the future. There is talk of warrants for some stakeholders but investors should probably not rely on that projected opportunity right now. Right now the future prospects of the company do not look good especially from an operational perspective until the operating costs improve substantially or commodity prices rally significantly. But a year from now when the company most likely emerges from bankruptcy, things could be materially different.
In the meantime, there are companies that prepared for this low price commodity situation very publicly that offer the potential of above average returns even if oil prices do not rally. Murphy Oil , Apache Corporation (NYSE:APA), and BP p.l.c. It would appear that an investment that relies on BP maintaining its dividend would be far less risky than investment relying on any of the speculative companies such as Energy XXI coming to agreement with their creditors. Plus most long term studies have shown that the majority of most investor gains involve dividends. Right now BP has a very fat yield that if maintained could lead to some substantial and lower risk gains. Plus those projected gains are very unlikely to prove illusionary. Meanwhile BP stock has a lot of failure priced into it which lowers the risk of loss. Investing in financially leveraged companies may be exciting, but investing in companies with operating leverage that are financially sound may prove more profitable. So as the curtain closes on Energy XXI and new opportunities present themselves in the future, let us hope that Energy XXI management learned from this experience and chooses a more profitable route in the future.
Disclaimer: I am not a registered investment advisor and this article represents my personal views. It is not an investment recommendation and readers are advised to evaluate their own risk profiles and determine whether or not this investment fits their own risk profiles. The reader is also advised to read the government filings of the companies mentioned for further information (they include but are not limited to 10-K, 10-Q and as well as the press release filings).
Disclosure: I am/we are long GXOCF, SDRXP,EXIXF.
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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