Why Leveraged Oil Stocks are Bad Investments

This week's Industry Focus episodes are all about looking back on our mistakes and learning from them, and what better mistake to look back on than recommending a soon-to-be bankrupt company?

In this segment, Fool contributor Sean O'Reilly looks back at 2015, when he recommended Linn Energy as his wild card pick of the week, and explains why it seemed like a good idea at the time, what he was failing to factor into his decision, and what this has taught him about investing overall and how to pick solid commodity players.

A full transcript follows the video.

This video was recorded on Aug. 24, 2017.

Sean O'Reilly: So, today is "We Said What?" week on Industry Focus.

Taylor Muckerman: So it is!

O'Reilly: We had to work hard, didn't we?

Muckerman: We did some digging.

O'Reilly: We had to work really hard. But we're all talking about, basically, times that we may or may not have made a boo-boo, mistake, made a wrong investment call --

Muckerman: May not have? We had to have.

O'Reilly: I'm hedging. [laughs] Which actually has a bearing on my mistake that we'll be talking about in a few minutes.

Muckerman: That's true. Foreshadowing.

O'Reilly: Dun-dun-dun! And basically, the takeaway is the importance of looking back, keeping a record, journal, diary, something, reflecting on your investing thoughts and processes because that's how you grow, that's how you learn. Hopefully you change and adapt over the years. The best investors in the world, of course, have changed their tactics. Buffett no longer looks for cigar butts. [laughs] 

Muckerman: Yeah, that was gross.

O'Reilly: Well, it made him $25 million, though.

Muckerman: It did, but not billions of dollars.

O'Reilly: Anyway, who's going first? 

Muckerman: I don't know! Pick it out of a hat!

O'Reilly: All right! Drum roll, please. All right, I lost or won, I don't know which --

Muckerman: Your error was slightly bigger than mine.

O'Reilly: It was so good, though!

Muckerman: It was slightly bigger than mine!

O'Reilly: We're going to talk about this. Austin, replay the clip now.

(O'Reilly): All right, so, this is my Hail Mary pick, and it's literally the best Hail Mary pass I could think of, which is LINN Energy.

(Tyler Crowe): He's going with a dirty, dirty, dirty value play for his Hail Mary.

(O'Reilly): They're down, what, 90% in the last year?

(Crowe): Something like that.

(O'Reilly): It's very sad. But they do have some of the best hedges around. I think we can all agree on that. And it's a Hail Mary pass because, if and when oil prices recover, if that were to happen in the next year or two, they would survive and possibly come out on the other end of it OK. They're about 80% or 90% hedged on their production this year, and that tapers off next year at about two-thirds, and then they're in trouble in 2017.

OK! So, one, I think I lost the fantasy draft.

Muckerman: Yes.

O'Reilly: Yeah. Although your winner, Silver Wheaton [now Wheaton Precious Metals (NYSE: WPM)], has come back down to Earth, which is fun.

Muckerman: It has. I have to go back to the spreadsheet.

O'Reilly: Did you update the numbers and everything?

Muckerman: Well, one company is no longer with us, and Spectra got bought out, so I need to go back and do some math.

O'Reilly: That's kind of a win.

Muckerman: I know. I think I'm still in the lead, but Silver Wheaton was my best performing at the time we had the cutoff.

O'Reilly: It was like, we did the picks in 2015.

Muckerman: Sept. 10, 2015.

O'Reilly: Oh my gosh, I can't believe I was talking to these losers then!

Muckerman: I know, seriously.

O'Reilly: I'm sure you feel the same way! But I was like, oh my gosh, it's been a while!

Muckerman: I didn't think it was that long ago, but it was.

O'Reilly: Yeah. I was listening to it, and Silver Wheaton went up the second we recorded.

Muckerman: Yeah, I think the peak was 70% or 80%. But, the gist was, we each picked three stocks. You, me, and Tyler Crowe all drafted three stocks. We had a stalwart, our No. 1 pick, the second pick was... I can't remember what it was, and then the third pick was our wild card.

O'Reilly: Of course, my loser that we're talking about now is the Hail Mary wild card.

Muckerman: Yeah, your waiver-wire pick.

O'Reilly: So, I said a couple of things, and I knew what I was going to talk about this episode, I was like, [groans] "I have to talk about LINN!"

Muckerman: Yeah, LINN Energy.

O'Reilly: "I don't want to, but I have to!"

Muckerman: What ticker is that on now? Is it on the Mexican Stock Exchange now? Can you even buy shares?

O'Reilly: No. The bondholders own it. If you haven't figured it out, listeners, LINN has gone the way of Chapter 11, bankruptcy.

Muckerman: The way of the dodo.

O'Reilly: I forgot that Tyler Crowe owned some shares, in reality.

Muckerman: Yeah, he did!

O'Reilly: We talked about that on that episode. Anyway, long story short, it was my Hail Mary pass. I knew I had to talk about it, but upon relistening to it, I was less depressed about the move, because I said it's a bet on oil prices recovering in the next year or two. They have not. Huge MLP. They were hedged 90% for the 12 months going forward from when I picked it. So again, they had some life. It was just when those things ran out, their massive debt load was just too much. It was the largest master limited partnership, MLP, in the United States at the time, I believe.

Muckerman: It was the belle of the ball.

O'Reilly: It was. And it was the largest, most successful MLP. The problem, of course, was that it's great when oil prices are high and they can make acquisitions and expand that distribution. But when you pay out 90% of your earnings in order to expand and grow said distribution, you need access to capital markets, and therein lies the rub. So upon reflecting on this, I now have a very solid rule, which I think I've talked about in the last month or something, but any commodity stock, they have to have some sort of cost advantage. And they didn't have that. They would just buy assets from other players, borrow money for cheap --

Muckerman: Yeah, they kept leveraging up.

O'Reilly: Yeah, that was it. And it works great if ...

Muckerman: You can keep producing. Yeah, and then, the fact that they had to pay out pretty much all of their net income to shareholders, doesn't leave you much wiggle room.

O'Reilly: I actually looked at the bonds of while ago, and the bondholders got some recovery value.

Muckerman: They did?

O'Reilly: They were not wiped out. The assets were still producing oil.

Muckerman: I mean, it is still land, but it's only productive if you have money to produce it. I think I said that right.

O'Reilly: I know what you meant.

Muckerman: It sounds like, "Duh, you have to have money to produce and make money." But they didn't, so they don't.

O'Reilly: It's impossible, because they all do this, but they were heavily leveraged. I think it was one to nine, the leverage ratio. They had billions in assets.

Muckerman: That was the business model.

O'Reilly: Yeah. So I learned from it. It was, admittedly --

Muckerman: Synthesize all that into, like, one key takeaway.

O'Reilly: Leverage is bad, especially with a commodity player. You know, a company that doesn't need capital to produce free cash flow, like a Google or something --

Muckerman: Yeah, or a software business.

O'Reilly: -- you can leverage that thing up and it won't matter. It will not matter. This, the leverage is like, you're walking around with this blade, and if you trip, game over!

Muckerman: Yeah, it's always facing you.

O'Reilly: And they didn't have a cost advantage. And at the end of the day, then, I believed that oil would recover far more quickly. And you know, nobody knows what's going to happen. But you need to have some sort of advantage. When you invest in a consumer brand or a stock or something, you need some sort of brand name like a Coca-Cola or a Gillette --

Muckerman: We call that a moat.

O'Reilly: A moat. And in commodities, you have to have that, it's actually even more important. And the only way to do that is some sort of cost advantage. It's evident in my No. 1 pick from that episode, which is EOG Resources. They're not showering money on their shareholders just yet, but they're still here and they're still kicking.

Muckerman: They're not on their deathbed, or, I guess, in the ground.

O'Reilly: Yeah. But their oil is.

Muckerman: They're not in either.

O'Reilly: Their oil is in the ground. So yeah, learned a lot. It's been a fun couple of years for oil.

Muckerman: Yeah, I know!

O'Reilly: A very good use case scenario for the business schools.

Muckerman: That price chart, man!