The Trouble with Oil (Part Three)

One thing that I’ve realized is that there’s a disconnect in how different investors think about oil. For asset allocators, oil and commodities are a financial asset. Volatility and drawdowns are viewed like those of a stock. Oil down 20% feels a lot like a stock down 20%.

For investors in oil company stocks and bonds, however, a 20% decline in oil is much more serious. A stock price primarily reflects a company’s equity and earnings prospects; oil, on the other hand, reflects revenue. A 70% drop in crude prices is like GE selling every product at 70% off. Framed it this way and you start to appreciate why alarm bells are going off around the world. To underscore the point, let’s look at a poster child of the oil boom-bust — Chesapeake Energy (CHK).

First, roll the clock back to mid 2014. Coming off a decade of exponential growth, Chesapeake’s market capitalization is close to $20 billion and enterprise value (market cap plus debt less cash) nearly $30 billion. With $4 billion in cash and shareholder’s equity of $18 billion, $11 billion in debt hardly seems excessive. Debt investors agree and allow the company to borrow at interest rates of 5-7%.

Fast forward to the end of 2015. The plunge in oil and natural gas prices has driven revenue down by well more than half. Frantic cost cutting has reduced expenses, but not nearly fast enough. Operating cash flow – before debt servicing – is now resoundingly negative. Sure, plenty of companies lose money in a given year. But this is different. Chesapeake has gone from a company that made $2.5 billion in operating profits in 2014 to one that could lose money, year in and year out, indefinitely.

What does this mean for the $26 million of equity and debt capital that went into the business to acquire properties and fund capital expenditures? The company itself wrote down its assets by $16 billion last year, or by around 50%, which practically wiped out common shareholder’s equity. Note that this was when oil was still comfortably above $50 per barrel.

Today, bond investors have a more dire view. Some bonds issued at par a few years ago are now trading below 30 cents. Yields to maturity are 30-40%. These prices imply that the whole company is worth less than $5 billion, down 70-80% in eighteen months. The equity will almost certainly be worthless in a restructuring; however, its stock still trades around $3 per share, reflecting an out of the money call option on the company’s assets.

This is a staggering change in valuation in a stunningly short period of time, and one that is happening to hundreds of companies throughout the commodity complex. If prices stay even close to these levels, recoveries on defaulted debt could well be pennies on the dollar. In a recent bankruptcy auction, Quicksilver Resources sold its US assets at a price that seemed to imply a 20-25 cent recovery for all creditors. Below secured creditors, payouts could well be zero. Consequently, when you read about default rates, also think about recovery levels. A 10% default rate with 20-30% recoveries is a far cry from one with 70% recoveries.

In this way, I suspect that the wash out in oil and gas bonds will look more like the telecom bust in the early 2000s. Back then, investors soon realized that having debt in a fiber optics company essentially was the same as owning equity. This turned out to be true for many mortgage backed securities, but on a much larger scale. Asset values simply weren’t stable. Google “bond bubble” in a few years and you’ll likely see much will be written about the madness of bond investors who lent money to oil and gas companies at paltry interest rates only to get pennies back a few years later.

February 1, 2016