Oil and gas stocks are on the rebound. After touching multidecade lows in February, oil alone has rallied over 80% to just under $50 per barrel. Those gains for crude have had a predictable effect on shares of producers, but beware: We're not out of the woods yet.
Despite this tantalizing rebound, and investors' natural desire to get in on a full-blown turnaround in the fortunes of the oil and gas sector, there are still a number of companies in the space that should be avoided. Many will survive this downturn and emerge stronger than ever; many will limp along; and some will be downright toxic to portfolios no matter what happens with oil and natural gas prices.
So, recognizing that the path to success starts by knowing what to avoid, some of the Fool's best and brightest put their minds together and came up with three oil and gas stocks to avoid at all costs right now.
Over the past couple of months, the dominoes in the U.S. oil and gas industry have started falling, with a handful of notable bankruptcies. EXCO Resources Inc. (NYSE:XCO) hasn't joined that dubious list -- yet. But the company could be one of the next to do so.
In mid-May, the company announced that it had formed a "special committee of directors to explore strategic alternatives," which is the kind of language companies often use not long before they file for bankruptcy, sometimes prenegotiated with lenders in order to speed the process through bankruptcy courts.
The catch? When a company files for bankruptcy, common shareholders are essentially guaranteed to get absolutely nothing, with debt holders and contractors rightly standing in line before shareholders when the assets and equity are divvied up.
That's not to say EXCO's case is hopeless. The company just went through a major board shakeup, and the board as currently assembled represents ownership of about half of EXCO's shares. On paper, that should be a good thing, and the company has taken steps forward to reduce its debt over the past six months, while also attaining improved covenants on its debt agreements.
Here's why EXCO could be toxic: The company still has a lot of work to do to lower its expenses, and the reality is, it probably needs to see oil and gas prices climb higher from here -- and for those prices to be sustained -- if it is to survive. In other words, as much good work as management can do, the company's future is still likely to be decided by market forces outside its control.
My nomination for an oil and gas stock that could prove toxic to investors' portfolios, Chesapeake Energy (NYSE:CHK), will likely not come as a surprise to many. The company has mountains of debt, is the second-largest producer of a commodity that until recently stood at multidecade lows (natural gas), and continues to sell assets at what may very well be a market bottom just to raise cash.
The problem with all of this, of course, is that if and when a sustainable turnaround in energy prices takes place, Chesapeake will be using that good fortune not to expand its bottom line, but to play catch-up and pay down debt. The company has $1.9 billion in debt coming due in 2017, with around $1 billion more coming due in each of the ensuing three years. True, the company has time and the likely means to contend with these maturities. Chesapeake recently convinced its credit facility lenders to maintain its $4 billion credit facility as is, sending shares and its own bond prices soaring. However, being granted survival should not be confused with being a great investment.
Chesapeake will likely survive the current oil and gas depression (thanks to its vast empire of monetizable assets). Unfortunately, its more efficient, lean, conservatively financed peers have been picking up assets and expanding their operations -- and will continue to. Downturns have the nasty habit of culling the herd: The strong get stronger, and the weak declare Chapter 11 or exist as ghosts. Chesapeake is a strong contender for the latter scenario.
Why else do you suppose ExxonMobil has seen its shares barely budge over the past two years? Everyone knows it will survive, nay, thrive. The same is not true of Chesapeake. With a debt-to-total capital ratio of 86.9% as of March 31, negative free cash flow in fiscal 2015 of over $2.5 billion, and mountains of debt coming due through the rest of the decade, Chesapeake Energy will likely prove toxic to portfolios, no matter what oil and gas prices do.
Shares of Whiting Petroleum (NYSE:WLL) have nearly doubled over the past three months thanks to oil's fierce rally off its bottom. However, don't let that strong rally fool you. This oil stock could prove to be toxic if oil takes another dive.
What makes Whiting Petroleum a potential portfolio toxin is the $5.3 billion in debt that is currently weighing down the company's balance sheet. It's a massive amount of debt for an $8 billion company. In fact, this debt is such a concern that one of the major credit rating agencies slashed Whiting's credit rating by five notches earlier this year, cutting it all the way down to Caa1.
That credit rating implies that Whiting Petroleum has substantial risks, which puts it in a vulnerable state. Moreover, it needs more favorable market conditions just to be able to meet its financial commitments.
While oil prices have recently become more favorable, there's a real risk prices could take another tumble. That's because companies like Whiting Petroleum have found ways to increase their output above initial projections even though the market is still oversupplied. If these output increases do start to weigh on oil prices, it could cause the company's debt to have a toxic impact on its stock, potentially causing it to give back all of its recent gains.
Jason Hall owns shares of Chesapeake Energy. Matt DiLallo has no position in any stocks mentioned. Sean O'Reilly has no position in any stocks mentioned. The Motley Fool owns shares of ExxonMobil. 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.