Should Investors Really Be Concerned With Bankruptcies in the Oil and Gas Sector?

Half of the current producers have no legitimate right to be in a business where the price forecast even in a recovery is going to be between, say, $50, $60. They need $70 oil to survive. -- Fadel Gheit, senior oil and gas analyst at Oppenheimer

Oil prices dropped below financial-crisis lows last week, marking a 12-year low for the commodity. The recent declines have sparked fears of bankruptcies that could affect a number of U.S. oil and gas producers. In fact, some observers say a third of exploration and production companies could go bankrupt. Gheit thinks half of the producers could enter bankruptcy. He notes that the likes of ExxonMobil (XOM 1.43%) and Chevron (CVX 1.42%) have never seen an environment like this and might need to think about their dividend policies.

With calls from major investment banks for oil to hit the $20 area, should investors be concerned? Let's touch on some bankruptcy history in the O&G sector and things that may need to happen before we see a bottom in the sector. 

We've seen this before
According to John LaForge, head of real assets at Wells Fargo, we saw north of 25% of E&P companies declare bankruptcy in the 1986-1987 period. He also mentions that once oil bottoms out, it usually takes another two months for the oil and gas companies to follow suit. Only 7% of the E&P companies have declared bankruptcy in the current downturn, which leads us to believe there may be more pain to come in the sector.

The drop in energy prices is the worst since 1987 when oil fell over 65%. However, companies continue to drill and pump despite the glut of supply globally and depressed prices. They have to keep pumping to collect cash at a loss to pay interest payments from the massive debt load in the industry. It will take bankruptcies for these businesses to stop as they lose access to capital. 

Yes, some bankrupt companies are able to continue operations and drill during bankruptcy. However, as bankruptcies pick up in the industry, the access to capital is a major concern as banks and investors will be unwilling to invest in energy companies that cannot make money in a depressed commodity environment. Bankrupt energy companies will continue to drill. However, it's not a winning strategy. This is a strategy that will work in the short-term and assumes that they will be able to access additional capital and negotiate better debt structures. The issue is the capital may not be there to save them all. 

Overseas, Saudi Arabia has made clear its intentions to increase production if U.S. demand increases. All indications have shown that we're experiencing higher demand already because of the lower oil and gas prices. But the U.S. oil industry isn't built for $30 oil. Still, that doesn't mean $30 oil won't stick around longer than expected. That's why investors need to look at high-quality businesses that can withstand an extended low-price energy climate.

In such a hostile environment, it's best to focus on companies with multiple revenue streams and great balance sheets. Such companies include many of the integrated oil and gas players, including Exxon and Chevron. Also, midstream companies such as Phillips 66 (PSX 2.07%) are likely to do well in a lower oil-price environment as demand and profit margins pick up.

It won't be easy for these companies. They've already cut spending, but they'll probably have to cut even more. I wouldn't be surprised to see these companies keeping their dividends as is or cutting slightly, but I don't see them cutting their payouts completely. Many of the companies in the energy complex are not generating enough cash to cover dividends with commodities at such depressed levels. 

Should we be concerned with bankruptcies
Bankruptcies happen at market bottoms. I would even go out on a limb and say they're a necessary evil to some degree because they wipe out a broad range of competition and weak operators in depressed industries. But that's not necessarily a bad thing. Less competition sets the stage for higher oil prices, and rising oil prices will be the signal to invest opportunistically for the long term in the oil and gas sector. Higher prices in commodities will signal to investors that the worst may be behind us. 

So should investors be concerned? Yes and no. In the short term, we need to navigate the environment to find the winners for the long term. We want to be careful in this environment, but we also want to be opportunistic and pick the higher-quality companies with the best balance sheets and integrated business models in the industry. This is a focus on companies with good debt-to-equity and debt-to-assets ratios. The companies with the best balance sheets will ultimately be the long-term winners as they're better positioned to weather the storm. As we can see in the chart below, the industry has a debt to equity ratio of 0.39 while Exxon, Chevron, and Phillips 66 all have debt to equity ratios at or below the sector average. 

Image Source: csimarket.com

It doesn't look like it's going to be a great year for the energy sector, but that also means it may be the time to start looking for opportunistic long-term investments by picking the companies with staying power. They're the ones that will benefit from the bankruptcies and market consolidation when the energy market recovers.