With Defaults On the Way, Will Big Oil Go Shopping?

Oil's low prices have stuck around much longer than so many originally thought. Now, more than a year later, we're starting to see companies like Penn Virginia (NYSE: PVA) and Magnum Hunter Resources buckle under the pressure. On today's episode of Industry Focus, our energy team looks at the implications and the lesson to learn from these companies' demise.

A full transcript follows the video.

 

Sean O'Reilly: We've talked about defaults before, but we mean it this time... on this energy edition of Industry Focus.

Greetings, Fools. I am Sean O'Reilly joining you here from Fool headquarters in Alexandria Virginia. It is Thursday, Nov. 12, 2015 and joining me to talk about all things energy and materials are Tyler Crowe and Taylor Muckerman. What is the good word, boys?

Tyler Crowe: Almost all things.

O'Reilly: Almost all things.

Crowe: There's some things we just can't talk about.

O'Reilly: We're going to talk about all the things in 20 minutes.

Taylor Muckerman: Solve everyone's portfolio issues in 20 minutes.

O'Reilly: All from this a 20x20 room in Alexandria, Virginia. So, first segment that I wanted to touch upon with you guys was... and David Gardner, of course.

Muckerman: Yeah, he's decided to join us.

O'Reilly: Yeah he's here, too. Oil's still in the 40s, things are not looking good for 2016. We talked about defaults before, but is every company but Exxon and Chevron going to go under before this is over?

Crowe: That might be pushing it.

Muckerman: Just a little bit.

O'Reilly: I like to speak in hyperbole for comedic effect.

Crowe: That is quite the hyperbole. But one of the things...

Muckerman: That would solve everyone's problems in 20 minutes or less.

O'Reilly: It would. Cure for low prices is low prices, baby.

Crowe: You know, we talked about this, when was it?

O'Reilly: Two months ago.

Crowe: January. Well, we've talked about it a lot. We've talked about it in November, we've talked about it in January, we've talked about it in March.

O'Reilly: But we mean it this time, darn it.

Crowe: I think one of the reasons that we haven't seen that reaction of defaults and people getting in financial trouble is, well, in all honesty, two things: One, I think a lot of people expected oil prices to be a little bit more robust than they are right now. I mean if we go back to November-December you hear all these wildcatter-style CEOs and guys like Pickens and stuff like that: We'll be at $70 by, in 6 months or...

O'Reilly: End of the year.

Crowe: End of the year, we're back at $70 and, you know, everybody kind of hung on to that and was like, "OK, we'll get through this. This sucks but we'll get there." And we're, what, 45...

O'Reilly: It's almost Thanksgiving.

Crowe: Forty-five to 50 days from the end of the year and we're still below $50. It's starting to really weigh on a lot of these people who thought they could weather a short-term storm and, well, that storm is a little bit longer than they expected.

In so many of these players that we had talked about, we knew they were going to be in trouble when oil prices were low. You looked at their balance sheets. You saw they had taken out a ton of debt, but at the same time I guess they just held on for a little bit longer and everybody expected it. I guess people are more resilient in that fact where they want to say, "We'll hang on. We'll hang on. We can make it through."

O'Reilly: Well, and the other reason that pain hasn't been quite felt is hedges, of course.

Crowe: That has helped to a certain degree. There are a lot of companies that have that in place especially when you look at, let's say, master limited partnerships that are in production. They have those hedges to kind of steady out their cash flows, but at the same time there are a lot of people who didn't have that have just had to slash their capital budgets, their operating expenses down to the absolute floor to make it as profitable as possible.

Some have been able to achieve some marginal level of profitability, which is quite commendable, but at the same time when you... again going back to their ability to pay off debts, it's getting a little bit harder.

Muckerman: I think some of the people that are facing these defaults probably didn't utilize hedges that much because they were those guys that were just saying, "Why are we going to forgo profits now with these silly hedges. This is going to crimp our returns now. Who knows what the future holds? What if oil prices stay at $150? These hedges are going to just, they're going to ruin our stock price."

O'Reilly: Was it Harold Hamm that cashed in his hedges a year ago now?

Crowe: Yeah, right about.

Muckerman: So, like I said, looking at these companies, you're talking about some names that were really popular names among investors, among the energy inner circles during the last four to five years of the boom leading up to November of last year. And now all of a sudden their debt is essentially worthless. At least that's what they're predicting in the next few months.

Penn Virginia I think is coming up on some covenants, Magnum Hunter Resources, they mentioned in the report that Tyler sent around, is basically already defaulting. And those two companies, while they're not huge, they're only domestic EMPs, but those are some hot stocks. Those were very, very popular and now they're reaching...

O'Reilly: So it was a little at 45 just because everybody's been holding on.

Muckerman: It's below 45 right now. It's almost 42.

O'Reilly: Oh yeah, it's 42, 43. Is it just holding on? I mean you see inventories continuing to creep up, but production is falling. Is it just people putting it there because they don't want to sell it at 45?

Crowe: Well, I mean again, to these companies they have to generate cash to pay these loans off to a certain extent. So they can't just shut off the taps. Especially like you said, Penn Virginia, and Magnum Hunter...

Muckerman: Magnum Hunter, the article said that they have debt coming up this month that they can't pay.

Crowe: So these companies, they can't turn off. They can't just stop producing because they need cash now. It's like those dumb annuity commercials. They always say, "I need cash now." But right now there's just too many of them out there.

O'Reilly: If only there was a payday lender for oil companies.

Crowe: There were, and now...

O'Reilly: Oh yeah, it's called Wall Street.

Muckerman: There were. Now it's gotten to the point where even payday lenders won't toss them a bone.

Crowe: And so, with those people that don't have that flexibility to say, "Well, we just can't stop drilling" or, "We can't stop producing," it kind of has compounded the issues that we have seen so far.

I mean obviously you've got some of the larger, more well-capitalized companies, the EOG Resources, ConocoPhillips, people like that, who have scaled back and said, "We can..." Even though some of them are more profitable at much lower prices today, they're still scaling back and saying, "You know, we can take our foot off the accelerator for a little while."

Muckerman: And that's not because they're smart now; it's because they were smart before. They weren't taking on these crazy amounts of debt. They weren't drilling out of control. It's kind of a domino effect here with these companies that they're able to do this because they were smart five to 10 years ago when they were first realizing that this is a gold mine, but it's not going to last forever. Because hey, the energy industry is...

Crowe: It's a cyclical business.

Muckerman: Yeah. They got it and some companies that didn't, it's evident every time the bottom hits or comes close. Some companies just didn't have the experience or the wherewithal to pace themselves.

Crowe: And certainly as investors and people like us, that couple years before, it was kind of one of those starry-eyed sort of moments where we looked at it and said, "We can take control of the market back where we can produce all of our own oil."

Muckerman: Energy independence.

Crowe: Energy independence. And seeing these companies that were just growing at gangbuster-like levels, almost doubling production every year, it sweeps you up. It really does as an investor, and you see all these companies that are just growing so fast and you want a piece of that. But at the same time again going back to the fact that it's a cyclical business, if you're an investor in this space, certainly a lesson I learned, in some ways the hard way from this one, is that we have to be measured in our approach throughout this entire -- through the down market and through the up markets.

That last one? We all got caught up in it and it probably burned quite a few people. And today at the same time don't overlook the fact that there's a lot of value in buying solid energy companies today. Don't just get burned back then and now today completely go away from energy. Because there are some opportunities out there. And when this market does turn, it will eventually, when it does you'll have some -- I think there's a great opportunity for some long-term rewards.

O'Reilly: So before we move on to this bottom line, it seems like some companies have got to die for production to really drop. I mean is that basically what we're saying here?

Muckerman: The crematories are firing up their furnaces.

O'Reilly: OK, that's dark but true.

Muckerman: Using oil to fire up their furnaces.

Crowe: Cheap, cheap oil.

O'Reilly: No, no, no, natural gas.

Crowe: Either way, they're both cheap.

O'Reilly: Well, before we move on, I wanted to point our listeners to a newly redesigned Focus.Fool.com. There you will discover a special offer. Join the Motley Fool Stock Advisor newsletter for all Industry Focus listeners. All loyal IF listeners have access to a special discount on Stock Advisor that works out to $129 for a full two-year subscription. Just go to Focus.Fool.com to take advantage of this offer. Once again, that is Focus.Fool.com.

And moving on to our second segment, I'm here with Tyler Crowe and Taylor Muckerman. Oil majors have... you're talking about the balance sheet of Exxon is like least cash, but they have $40 billion or something.

Crowe: That and then all the stock that they have of their own.

O'Reilly: Yeah, the treasury stock.

Crowe: Yeah, the treasury stock, yeah.

O'Reilly: So oil majors have cash to spend but they haven't been making a ton of acquisitions, and then the devastation in the oil industry has been going on for over a year now. Do you guys think they'll actually start shopping at some point?

Muckerman: Well, I think we talked about it a little while ago as well when we were talking about Exxon's cash balance, that they kind of need that cash in order to sustain dividends. Because if not, the cash for operations isn't going to sustain that if oil is the in $40 range. And Exxon is addicted to the share buybacks, so they'll have to cut that even more if so. So the cash has kind of been held as a necessity.

Obviously if these companies start going bankrupt like we've talked about in the previous segment, there's going to be some opportunities. And these companies that are failing aren't necessarily failing because they have terrible assets. They're failing because they were run terribly. So they're going to be out there for the cheap and yeah, there will come a point where Exxon and the like decide, "I think we have enough to sustain our dividend for the next year or so. Let's go ahead and spend."

Not at, like, $10 [billion]-$20 billion, but let's go out and spend $500 million, a billion here and there, to go ahead and pick up some lucrative assets in Texas or where the Utica base center, something along those lines. They're not going to reach with this cash. They're going to be safer bets that are very cheaply valued in my mind.

Crowe: Yeah, and I mean, I think this is on everybody's minds again now because we just heard the recent talks of -- there was a story came out on Bloomberg that Apache (APA -1.26%) had been courted by somebody.

Muckerman: No small company, mind you.

Crowe: Yeah, they're a pretty formidable-size company. So when we heard, when you hear somebody of the size of Apache getting acquired, everybody's fingers immediately point, "Oh, it's going to be Chevron. Oh, it's going to be Exxon. It has to be one of these guys because they're the ones that have capital."

Surprisingly, it came out that it was actually Anadarko Petroleum (APC) that did it, so now that that has happened, it just goes back to everyone talking about big oil. "Oh, they've got the cash, they've got the Treasury stock, it must be those guys. When are they going to make their move?" And we've been wondering that for a long time. We looked at it and said, "Oh, these companies are so cheap and some of them are really looking distressed. They can get them on the cheap."

But at the same time, the situation hasn't exactly improved from back in February-March to today. And a lot of, if you listen to the conference calls of the companies that we're talking about -- ExxonMobil, BP -- all them are still kind of preaching that idea that, "Hey, guys, we could be in this for a lot longer than some of these wildcatters. Oh, we'll be back in 6-12 months." Big oil is like, "Hey, guys, this could -- 2016-2017 might be, maybe, when we start to receive recovery, but it could take that long." And so if you are one of the buyers or potential merger people in these companies, why bother? Why bother with making a...

O'Reilly: You could buy some in bankruptcy court.

Crowe: Yeah, you could buy something later when it's even cheaper, or even when it's more distressed. Or maybe wait a little bit longer because you have some efficiency programs you want to get through and you're now all of a sudden starting to generate some cash from these low oil prices, which we are starting to see from some players, surprisingly. And once that comes around, that could be certainly a more attractive opportunity. I mean when the name Apache came out, what made that so attractive to a lot of people, if you look at Apache's assets they have a very strong presence in the Permian Basin.

And the Permian has historically been a huge oil and gas producer for us in the United States and with shale starting to take hold, everyone started to say well, with all that acreage there, somebody that has a decent position in the Permian like Chevron, that could really compound that and become one of the key drivers for them, pull in this, in their next wave of development. You know, 2017 a lot of the things that they've been working on are starting to wrap up and everyone's starting to wonder what are they going to do next. And somebody like Apache could be a big lever for them to pull later on.

O'Reilly: Now you guys may or may not be able to answer this so it's totally fine, but maybe you just take a stab. At what point, and to Taylor's point, he's talking about Exxon's committed the dividend, they want to hold on to this, that, and the other thing, they also need to balance that I assume with just reserve declines. At what point do they need to be like, "Yeah we should probably buy one of the smaller guys just to up our reserves or something?"

Muckerman: Most of these guys are generally breaking even or just barely growing reserves year over year. The recapitalization, is that...?

Crowe: Yeah, the replacement rate.

Muckerman: Replacement ratio they generally want to keep that like 100 so that they're right there. You see it fluctuate between 95 and 105. So some years they'll be a little less, some years will be a little more, but generally these companies are big enough to where they're just trying to stay steady, right?

And if the price of oil, which is what they kind of base their reserves on, on their balance sheets, going to stay this low, then it will continue to decline. And yeah, the only way to really boost that is through acquisitions, because they would have to drill a heck of a lot to move the needle in terms of how much they're producing and selling.

Crowe: And at least in terms of, again, big oil, they're not in a huge rush. I mean, somebody could say there's a panic because ExxonMobil doesn't completely replace its reserves in a single year. They have if -- not just prove, but if you look at their kind of pipeline that they talk about, of potential reserve -- they have 90 billion barrels of potential reserve.

O'Reilly: Just hanging out.

Crowe: Just, they're working through that, they haven't, you know it's like it's not in our prove reserve because we haven't dropped them into our balance sheet. But it's like, we're working on 90 billion barrels of potential oil. So they're not in a huge rush in any way to go do this. And I think one of the important things that they're going to look for is not just cheap, not just, you know, grow reserves, but fit.

What is going to be a company when they bring them on that is going to be a good strategic fit? Royal Dutch Shell has been looking to make their purchase of BG Group, because they're like, "We're going to make a big splash into LNG." And so with the BG Group, they're kind of pushing more toward LNG.

So if you have somebody like ExxonMobil or Chevron who may be making some big move in the future, they're going to want to find something that really fits within their development portfolio that they can not only develop, but kind of combine with what they have and get a lot of cost savings and things like that.

I certainly -- after ExxonMobil made that XTO purchase in 2011, it took them a few years to figure it out. And I think they learned a lesson from that.

O'Reilly: Cool. Well, last little thing before we go, we have a mailbag question, guys.

Crowe: It's been awhile.

O'Reilly: It has been awhile. And actually on that note, if you have a question or comment for Tyler or Taylor, please email us at [email protected].

Crowe: Or Sean, if you want to ask Sean a question.

O'Reilly: Or me.

Muckerman: Tweet us @TMFEnergy.

Crowe: Any way you can get in communication with us, we'll find a way to answer your question.

Muckerman: What was that email address, Sean?

O'Reilly: [email protected].

Crowe: Sorry, I interrupted you.

O'Reilly: Anyway, that's fine.

Crowe: Stop playing on your phone, Taylor.

O'Reilly: So, Jonathan...

Crowe: Rossignol.

O'Reilly: Rossignol, thank you.

Crowe: It's a skier? I don't know.

Muckerman: I don't know.

O'Reilly: Maybe. Writes, "I would like to hear your guys' opinion on midstream energy limited partnerships. Do you have past experience with them? Are they too risky under the current market conditions? How reliable are the dividend yields for the long term?" This is particularly pertinent because those yields are, like what, 10-20% right now?

Crowe: Well, depending on where you look at in the space. It is a rather broad-stroke question in the fact that, are they risky? I think when you say that, it really depends on who you're looking at. And so...

O'Reilly: So who are the risky people? Just a couple names for the...

Crowe: Well, I would say I think one of the general things that you should look for, when you're looking to purchase a midstream limited partnership, I wouldn't say that it is a risky environment now. I think of all the investments you can make in the oil and gas space that is one of the lower-risk opportunities.

And one of the reasons for that is that when it comes infrastructure, most of the stuff that they do is based on long-term fee-based contracts. That's the thing that you really want to look for. A company that has 80% to 90% of their revenue or profits generated from these fixed-fee contracts...

O'Reilly: They're a toll collector. Game over.

Crowe: Yeah, and you're just basically sitting there and buying the cash for it. For those that are a little bit more leveraged prices, people who are probably more focused on gathering and processing, you might see a little bit more variability in that cash flow, which could make them a little bit shakier.

And I think you can see some of the dividend yields of those companies showing that as of late. So if -- for Jonathan, I wouldn't completely avoid the sector in that broad stroke sort of way. Look at the structure of the company, how do they generate their revenue, and make your decision from there. Because I think there are a lot of opportunities in -- lower-risk opportunities in that space that are very attractive right now.

O'Reilly: Taylor, are there any names that come to mind that you like right now?

Muckerman: Right now, probably the bigger, the better. Kinder Morgan. Kinder Morgan's taking a big hit lately. Personally, we recommend...

O'Reilly: What's the yield on that? Is it like, 6, 7.5?

Muckerman: I don't know off the top of my head.

Crowe: It's 7 right now.

Muckerman: Yeah, it took a hit over the last month or so. I know it's a Fool favorite and a lot of services, Spectra Energy's a recommendation in Stock Advisor Canada on our U.S. side of the scorecard. That's probably one of my favorites. I personally own that as well.

O'Reilly: Now they're mostly natural gas, right?

Muckerman: Correct, and they're not nationwide or even in Canada. They have a small presence in Canada along the Great Lakes, but predominantly East Coast all the way down to the Gulf. And yeah, like you mentioned, natural gas is the bulk, and natural gas liquids are the bulk of their business.

And then one thing obviously you want to find a good company, but then you have to take into account the tax implications, the K-1 form you have to file, long term this could be advantageous because you're kind of deferring some taxes. But when you sell it, there are tax implications on the units that you own. So you definitely want to kind of understand that a little bit more. I guess Spectra Energy isn't really an MLP, is it? They own MLPs...

Crowe: Neither is Kinder Morgan. They're both C corps. We just recommended two C corps when talking about limited partnerships.

Muckerman: I guess that gives you my feeling on it.

O'Reilly: Enterprise Products Partners?

Crowe: Enterprise Products Partners.

O'Reilly: Yeah, there we go, yay!

Muckerman: ...I give you my opinion on MLPs, I don't personally care for them all that much just because of the added tax structure. But there are companies like Spectra.

O'Reilly: Don't be lazy, Taylor.

Muckerman: Choose Spectra Energy or Kinder Morgan if you want an infrastructure company without having to deal with the MLPs.

Crowe: As somebody who owns them, one of the things I would recommend is you buy to own. You don't buy to trade in any way because of the weird tax things in terms of dividend recaptures and, like you said, the K-1. If you're buying it and just holding it forever, yeah, you have to fill out an extra form come tax time. It's not a huge deal.

Muckerman: Not the biggest...

Crowe: But if you're moving in and out of these positions, they can be a pain in the butt.

O'Reilly: These are definitely things you give your grandkids kind of stuff.

Muckerman: Yeah, that sort of thing.

O'Reilly: Cool. Very good. Well, thanks for your thoughts, boys.

Muckerman: Well, maybe you could look at Spectra Energy Partners or DCP Midstream.

Crowe: Here, he goes, just throw it. Oh, I've got to find something.

Muckerman: Obviously, I like them if I like Spectra because Spectra owns them both; they're general partners. So, take a look if you like MLPs. Maybe they're worth it.

Crowe: Trying to keep it together.

Muckerman: Don't just let it go.

O'Reilly: It's fine. Oh, you get... I'm just kidding. Well, that is it for us, folks. If you're a loyal listener and have questions or comments, we'd love to hear from you. Just email us at [email protected]. Again, that is [email protected].

As always, people on this program may have interests in the stocks they talk about and they may hate filling out K-1 forms. The Motley Fool may have recommendations for or against those stocks as well. So don't buy or sell anything based solely on what you hear on this program. For Taylor Muckerman and Tyler Crowe, I'm Sean O'Reilly. Thanks for listening and Fool on!