Oil Change: The Black Oil Stock You MUST Sell Now

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1 AGOR A financial Oil Change: The Black Oil Stock You MUST Sell Now When oil recently climbed from $30 to over $50, investors were clamoring to ride the momentum. We saw an endless stream of rapid-fire buy recommendations for small, high-cost oil and gas companies coming out of Wall Street. No surprise there. The herd mentality is strong. But that doesn t mean it s right. Oil is a volatile commodity. So when we see another increase, we ll also see another round of reckless buying. Two problems oil investors will face First, the price of oil is still far below the threshold where these companies were making a lot of money. And second, even if oil prices manage to rise significantly in the coming months, the uptick won t last long. A growing threat to the oil industry will prove devastating to these companies in the very near future. I m talking about the dawn of new, cleaner forms of energy. Indeed, as consumers begin powering their homes and automobiles with alternatives like lithium, it will lead to one inevitable outcome The death of the oil industry. In fact, certain companies are already flashing warning signs even in these early stages of oil s decline. So let s review three oil companies that have no place in your portfolio right now. Each of them may appear tempting on the surface, but as we take a deeper look, it s clear that they re all rotting from the inside out. IMPENDING OIL DISASTER #1: Bonanza Creek Energy, Inc. (BCEI) Bonanza Creek s story is the most tragic of the three companies in this report. It didn t really do anything wrong it didn t make massive upfront payments, it tried to keep debt at reasonable levels, it kept control of most of their operations. In fact, companies like Bonanza Creek, which were part of the fracking revolution, have brought the United States closer to energy independence than at any point in decades. But that isn t going to save the company in the new oil price environment. Even if oil prices recover, Bonanza Creek just isn t going to make it. In fact, Bonanza Creek is going to be among the first to go bankrupt. The company operates in the shale and oil sands areas. To be sure, those oil sands are more productive than the ones you might have read about in Canada, where they have to be treated under high temperature and pressure just to extract the oil in them. But it s tricky and expensive to get the oil out of these and that s going to prevent Bonanza Creek from coming back. Compounding the issue is the fact that the company has relatively few hedges against future price declines. Bonanza Creek s main operations take place in the Wattenberg Field in Colorado and the Cotton Valley of southern Arkansas. It has a third operating area in Wyoming which it was trying to sell, but it s been taken off the market due to an absence of buyers. Both Wattenberg and Cotton Valley are old oil fields they ve been producing oil and gas for decades. Bonanza Creek s strategy was to acquire old properties in these afinancial.com

2 areas that had been abandoned or nearly abandoned and use horizontal drilling and hydraulic fracturing techniques to squeeze more oil out of the land. What that means for investors is that Bonanza Creek s cash cost of producing a barrel of oil or its gas equivalent was $8.77 per barrel. That doesn t sound so bad. But it comes nowhere near generating enough cash to service the company s debt or to reinvest enough money to keep production at current levels. In fact, the company has already skipped a major interest payment. Without a major balance sheet restructuring, bankruptcy is imminent. What led to the liquidity squeeze? The falling price of oil led Bonanza Creek s lenders to re-value the collateral backing the company s loans. In Bonanza s case, the re-valuation reduced the size of the company s credit facility from $475 million to $200 million. At the time, it had $273.3 million outstanding under those loans. In other words, Bonanza is overdrawn. It s made the first three payments toward reducing that overdraw to zero, but future payments are in doubt. And to make matters worse, the banks are about to re-value that collateral again. There s a general tool for valuing oil and gas assets called PV-10. Essentially, it takes the value of the a company s potential oil (what s currently in the ground) less the company s best estimate of the cost of drilling that oil and bringing it to market, discounted by 10% per year in order to reflect the risk of the estimates. The Securities and Exchange Commission requires publicly traded oil and gas companies to disclose this number each year. Bonanza Creek s PV-10 at year-end 2014 was $1.341 billion. At the end of 2015, it had fallen all the way to $327.8 million. Ouch. So, what happened? Did a bunch of oil simply disappear? No. It s just that the value of the oil has declined so severely. Bonanza Creek just cannot support its $1.066 billion debt at anywhere near current oil prices. In fact, the company paid the interest due on some of its bonds 30 days late one day before the bondholders would have had the right to declare the company bankrupt whether Bonanza agreed or not. These dire straits have Bonanza trapped. The company has tried to sell some assets to raise cash. But potential buyers don t want to take the risk that any deal they cut would be reversed by a bankruptcy court. So they re all insisting that Bonanza fix its debt situation before they ll agree to buy any assets. But without selling assets, the company can t reduce debt a Catch 22 that will result in Chapter 11. Bonanza has already hired restructuring advisors, but with most of the company s debt held by diverse bondholders instead of a few banks, a consensual restructuring will be all but impossible. The advisors will tell Bonanza the one thing they don t want to hear bankruptcy is the only way out. Common shareholders are likely to be wiped out or given a token stub in the company that emerges from bankruptcy unless oil prices recover significantly and within just a few months. Now is very much the time to get out of this stock. IMPENDING OIL DISASTER #2: W&T Offshore (WTI) The company was clever to adopt the ticker symbol, WTI. It evokes instant credibility, since those letters also stand for the highest standard of crude oil, West Texas Intermediate. The problem is, that s where W&T s credibility ends. W&T specializes in offshore drilling in the Gulf of Mexico. The company operates 14 projects of its own and is involved in six projects that are operated by other companies. Together these projects are expected to produce 15.6 million barrels of oil equivalent during Oil equivalent refers to the fact that many wells, including almost all of those in the Gulf of Mexico, produce both oil and gas. Therefore, the companies, lenders, analysts, and others convert their means of production into the others equivalent at a rate of 6 thousand cubic feet of gas to one barrel of oil. W&T s projects, and the ones it invests in, are divided among the shelf, deep shelf, and deep water areas of the Gulf. The good news for W&T is that Gulf projects are tremendously front-loaded - which is to say that a huge portion drilling expenses are paid upfront when a well is established and hooked up to pipelines This means the company s ongoing costs are below the price of oil, so they do generate positive cash flow from their production. The bad news is that the positive cash flow is nowhere near enough to cover those upfront 2

3 expenses, which W&T funded largely with debt. W&T is, therefore, one of the Walking Dead it s conducting enough cash flow to keep producing oil but not enough to survive without a restructuring, and certainly not enough to grow. The company invested in big projects funded by debt confident that the price of oil would stay high forever. But most of its projects aren t even under its control. Instead, it just owns a piece of the production and someone else operates the project. That s not uncommon in the oil industry. It s not that different from buying oil futures on the commodities exchange. Just riskier. Of course, W&T is now paying for its bad bets. At current oil prices, the company is losing money with every barrel it produces. And the situation is only getting worse, considering that W&T is constantly overdrawn on its credit agreement. The government wants more bonding to cover the work the company is currently doing in the Gulf of Mexico and they don t have the money. It s cut its capital expenditure budget to the bone, meaning there s no way to grow out of their predicament. Basically, this company is just trying to survive long enough for prices to come back. W&T recently completed an exchange offer that diluted its current stockholders in exchange for some relief from near-term debt maturities. The company reduced debt by $400 million, but reduced shareholders by more than 40%. The new bonds are a combination of second lien and third lien bonds and these are of interest to whichever parties ultimately battle over this company s carcass in bankruptcy.. And the new bonds will give the company the option of paying interest not in cash but in new notes for 18 months to two years. However, this is not important for our purposes here thank goodness. Why would a bondholder accept a package worth only $571 for their $1000 bond? Especially if the new bonds might not pay interest in cash, the whole purpose for investing in bonds in the first place! Well, if the new notes could be expected to trade at their full value, it would be a huge windfall for bondholders, because their bonds were trading around $300 per $1000 bond right before the exchange. But the new bonds will trade at a discounted rate. The bondholders accepted because they were desperate for some kind of lien on the company s assets in order to protect their investment when bankruptcy eventually hits. OIL S WALKING DEAD CYCLE With oil at such depressed levels, a smart, well-capitalized producer might cap his wells and wait out the price decline. But these debt-funded producers can t do that. They need the cash flow now to have any hope of avoiding bankruptcy. But their continued production will keep oil prices down, depressing the earnings ability of the remaining companies and causing even more bankruptcies. This dangerous cycle can keep indebted companies alive, but just barely. The bottom line is that these oil companies will NOT stop producing oil and, ironically, that will keep prices too low for them to profit. The bondholders know what the future holds for this company. It probably won t make it without bankruptcy, even after it s dilutive debt deal. If it s part of your portfolio, I urge you to sell this stock. To get a better sense of W&T s dire condition, let s go back to that PV-10 we ve previously discussed. W&T s PV-10 value after estimated asset retirement obligations for 2014 was $2.3 billion, pre-tax. At the end of 2015 that value had dropped to $614 million. Again, no oil disappeared. The decline is related to the price of oil and gas. Not only is the value of the company s production reduced, the future production also goes down because some of the oil and gas that the company knows is under its wells cannot be drilled and moved to market for even a penny of cash flow. And by comparison to that $614 estimate of future cash flows, the company s debt - even after its dilutive deal, is over $1 billion. There s a $400 million shortage before equity owners see any value from this company. It could be that oil prices will rocket back to $90/share and that PV-10 will go back up above the level of debt. But I doubt it. There s more bad news. The government wants some money, too. You see, the government is worried about oil spills in the Gulf of Mexico, and for good reason. 3

4 The law requires companies to put up a bond that covers the costs of decommissioning wells, but will give an exemption to companies with a high enough net worth that can clearly cover the costs on their own. Well, W&T can t cover those costs now at least in the view of the Bureau of Ocean Energy Management, which decides such things. It s demanded that W&T put up a bond assuring the costs will be covered, to the tune of $260 million. The company is trying to negotiate that amount down and is in discussions with surety companies in order to provide such a bond, but it will be on the hook for an enormous amount of money very soon. IMPENDING OIL DISASTER #3: Mid-Con Energy Partners (MCEP) Mid-Con Energy Partners operates mostly in Texas and Oklahoma, with a small presence in New Mexico and Colorado adjacent to some of its primary properties. This company made a grave mistake early on, unlike the other two, which had strong starts. The error was that it tried to profit from high-cost properties via waterflooding. This process involves injecting water into an oil field in a pattern around a well. The water creates and expands fissures in the rocks of the field. The objective is to free trapped oil, once the easily accessed oil has already been extracted. The problem is, it s more expensive than traditional drilling methods. Bringing in all that water, pumping it into the field, creating pressure, regathering the oil and gas, separating the product from the water all of this adds up. In Mid-Con s case, the cash cost for producing a barrel of oil is around $18 per barrel. Production taxes raise that to $ Add in the cash costs of running the company, and it goes up further, to $ Now if you include the company s minimal maintenance capital expenditures just what it has to spend to keep the wells going, which have been cut to the bone it takes $29.56 to produce a barrel of oil. And that s before the company has paid any interest or made any distributions to stockholders (which are currently suspended and are unlikely to be resumed with the company s current structure). You may think that if the price of oil rises to $50 and beyond, a cost of $29.56 per ounce isn t necessarily so bad. But the price you see on the news is what they call a benchmark price. Specifically, it refers to high-grade oil delivered at one of a few places in the Midwest. For Mid- Con s oil, in the places it s produced, the company s average realized price was $ In 2015, on average, Mid-Con received $5.78 per barrel less than that benchmark price. These figures clearly aren t sustainable. In fact, there are only three reasons the company isn t already bankrupt. First, it cut capital expenditures below the minimum maintenance level. It s possible to do that for a quarter or two, but after that, rigs start failing, oil starts spilling, people start getting hurt. It s not a viable strategy for even a moderately long period of low prices. Second, the company successfully sold hedges against much of its oil production back when prices were high. Including the effect of these hedges, and the company realized over $40 per barrel in revenue. And third, the company recently raised some capital a rarity in the oil industry these days. But at least some of that capital spending has to come back, some of those hedges are about to go away, and the capital it raised only compounds problems for current equity holders. Originally, Mid-Con sold hedges covering more than half of its scheduled production through the end of A strategy that looks very prescient right about now. But the banks are going to make the company sell many of those hedges and give the profits to the banks. The reason is, once again, the borrowing base. Each spring, banks revalue a company s oil and gas holdings using current prices to determine how much they re willing to loan a company. The low current prices meant that Mid-Con s borrowings were about $50 million higher than the banks were willing to lend more than onethird higher. Mid-Con doesn t have access to the capital necessary to pay back the overage. So the banks are in control. The company s new agreement allows for a $110 million conforming borrowing base and a $53 million non-conforming base. Mid-Con has an asset sale about to close, and all $18 million of that sale will have to be applied to the debt. But that still won t get the debt down to the banks required 4

5 level. So the company has to make principal payments against the non-conforming portion of the loan. And Mid-Con has to sell the hedges for the period from July to September with all of the money also going to the banks. In fact, the sales should already have occurred, but the company hasn t yet updated its public statements to reflect this, so we don t know what the sales cost, how much money it raised, and on what basis the company was able to enter into new hedging contracts. But wait. There s more. Like I said, banks generally re-value a company s properties in the spring. But in Mid-Con s case, any bank has the right to run a re-valuation between September and November of this year. And you can bet if oil prices go lower, the banks will do just that, decreasing the allowable borrowing base even further and probably requiring the company to sell more of its valuable hedges to stay alive. Essentially, Mid-Con works for its banks. Even after the capital it raised, which put it back into conformance with the banks at least for now. Mid-Con is a textbook example of the Walking Dead. It no longer has a will of its own, it s just producing to meet the insatiable hunger of its banks. The company s PV-10, at $191 million at the end of last year, is actually larger than its debt. But because of its high costs, Mid- Con is more sensitive than most companies to further declines in oil prices. way out of the situation in the short term and the protection of bankruptcy will actually give them more flexibility than the banks will. Mid-Con s stock recently rocketed upward because it completed a sale of $25 million of preferred stock. That money funded an acquisition and paid down some debt so Mid-Con is now conforming on that previously non-conforming credit agreement. But don t be fooled. It solves the company s problems for right now, but only for right now. It s telling that the people funding this capital didn t want common stock they received preferred stock - ahead of common stockholders in the event of the company s eventual bankruptcy. Some of the savviest investors in the oil industry are lining up to get a piece of this company, but they re lining up ahead of stockholders. Oil s Days Are Numbered One key takeaway here is that each of these companies is from a different segment of the oil industry. So the problem doesn t lie with only one kind of producer. The coming devastation will hit the entire industry to its core. Avoiding these stocks at all costs will help save you from the coming catastrophe. Ahead of the tape, If Mid-Con is to survive, it won t be enough for oil prices to recover. It has to recover by a lot, and very soon. There are no signs that this is going to happen. It s at this point that I expect management will realize there s no Louis Basenese Investment Director, VentureCap Strategist Copyright by Agora Financial, LLC. 808 St. Paul Street, Baltimore, MD All rights reserved. No part of this report may be reproduced by any means or for any reason without the consent of the publisher. The information contained herein is obtained from sources believed to be reliable; however, its accuracy cannot be guaranteed.