It's crossed your mind: You know there just have to be some great value stocks -- the kind that will generate multibagger returns when the inevitable recovery happens -- buried within the energy sector. These opportunities don't happen every day -- one need only have the courage to step up to the plate and buy when others are selling.
Right? Well, not so fast.
True, the sector is far off its highs. And true, oil prices have recovered a bit since their February lows, thus suggesting that a recovery may very well be under way. But it is equally true that sometimes, investors are selling a company's shares for good reason. In fact, there are times that investors should hate certain companies, no matter how "undervalued" they appear.
So in the spirit of becoming successful by avoiding failure, here are three oil stocks some of the Fool's best and brightest truly despise, despite their apparent attractiveness.
I've soured on Chesapeake Energy (NYSE:CHK) over the past year. That's after watching the company burn through nearly $5 billion pursuing production growth at a time when the market clearly didn't need that incremental production. In doing so, the company's management team put it in an even more precarious financial position that could lead to its collapse if commodity prices don't continue to improve.
What has really bothered me about the company is that CEO Doug Lawler was hired to right the ship, which had been sinking under mounting debt after years of wild spending chasing growth. However, instead of cutting capex to match cash flow as had been expected, Lawler basically continued down the pathway of his predecessor, nearly running the company into the ground. As such, I'm just not convinced that this company will ever create any lasting value for investors outside of a massive spike in the price of natural gas.
Chesapeake Energy might possess some of the best shale assets in the country, but the company just doesn't seem to know how to create value out of its assets. That's why it has become the one energy stock that I really loathe.
As much as I hate to kick 'em when they're down, I have to go with Transocean (NYSE:RIG) as an energy stock that I love to hate. Many an enterprising investor, picking through the wreckage that is the energy sector today, has had his or her interest piqued -- for good reason at first glance. Transocean trades for just 25% of its tangible book value, generated over $1.4 billion in free cash flow last year, and languishes a full 78% off its highs of summer 2014, when oil last traded at $100.
Sounds tempting, right? Alas, the devil is in the details.
Transocean is the world's largest offshore drilling contractor, with some 40 drilling rigs in its fleet and a specialty in ultra-deepwater operations. That last fact should be cause for worry. Drilling for oil at those depths, with the associated risks and costs, requires a much higher oil price than exists today. Adding insult to injury, customers continue to terminate contracts and cancel orders. These alterations aren't meant to be in effect until oil rebounds, either. Five high-specification jackups have been deferred until 2020, with all payments associated with these rigs being deferred as well. Mix a tough rig market with Transocean's massive debt load (the entire enterprise sports a debt-to-assets ratio of 55%), and top it all off with its spectacularly elderly fleet, with an average age of over 19 years, and you've got a stock worthy of everyone's ire.
The offshore oil and gas industry is in the midst of an epic reset. Producers with offshore assets have become even more reluctant than onshore companies to invest in resource development, and that's playing havoc with offshore drillers such as Seadrill Ltd. (NYSE:SDRL).
What makes Seadrill a company I love to hate? It comes down to how management sailed into the downturn aggressively ordering new vessels, paying a dividend nearly double that of its profits, and largely using debt to sustain both actions.
It worked great -- right up until it didn't:
Seadrill's management did a terrible job allocating capital in the years leading up to the 2014 oil crash. In the five years before the dividend was cancelled, the company paid out more than $6 billion in dividends and ran up about $7 billion in additional debt at the peak:
Furthermore, management misled investors about the stability of the dividend, even as oil prices were falling and demand for offshore drilling vessels dried up.
Here we are nearly two years later, and demand is only weakening further. Seadrill has nearly a dozen vessels coming off contract this year, and another 14 newbuilds it has paid money toward, that may not be in demand for another couple of years.
Yes, management has reduced its debt and may yet make more progress, but it's a mess entirely of its own making, by insisting (or letting a certain founder insist) on paying an outsize dividend and using debt to fund newbuilds.
Shame on me (and other investors) for believing management, despite the evidence that it was wrong about the sustainability of the dividend, or the risk of so much debt and aggressive growth in a cyclical industry where downturns can be rapid and severe.
But shame on Seadrill management for not doing a better job of managing the business, its assets, and its capital. You've made it pretty easy to hate you.
Jason Hall owns shares of Chesapeake Energy and Seadrill. Matt DiLallo owns shares of Seadrill. Sean O'Reilly has no position in any stocks mentioned. The Motley Fool recommends Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.