After dipping back into the $40s earlier this year, crude prices have come roaring back and are currently in the upper $50s. While that's a far cry from where they were a few years ago, the oil market is in a better place today than it has been for quite some time. Because of that, optimism and a sense of normalcy are starting to return to the sector.
However, before we bid adieu to the oil market downturn, I thought now would be a good time to reflect on some of the investing lessons I learned from the oil price crash. While painful at the time, these nuggets of wisdom will make me a better investor in the future because I'm much more aware of the red flags that can quickly obliterate a once-promising investment.
No. 1: Debt can quickly destroy what took years to build up
More than 100 oil companies in North America have filed for bankruptcy since the oil price crash began in mid-2014. The problem was that these companies took on too much debt during the boom years to expand and couldn't pay it back when crude crashed. One of those that sank under the weight of its debt was SandRidge Energy (SD -2.00%). Once a darling of the shale sector, Sandridge piled on billions of dollars in debt to buy drillable land and drill as many wells as possible. The company aimed to increase production fast enough so that it could grow into its balance sheet. However, crude crashed before that time ever came, and despite working hard to shed assets and repay debt, the company filed for bankruptcy in May of last year after suffocating under the weight of $3.7 billion in debt.
The SandRidge bankruptcy was one of three that stung my portfolio during the oil market downturn because I let the potential for outsized returns cloud my vision. However, I've learned from that mistake and am now intently focused on the strength of a company's balance sheet over those of its growth prospects. That's because growth prospects can change on a dime while having a strong balance sheet enables a company to live and fight another day.
No. 2: Liquidity isn't liquid if it's not cash
In that same vein, another lesson that got burned into my investing brain is that when a company talks about how much liquidity it has to get through tough times, if it's not talking about cash in the bank, then it's skating on thin ice. One of the many examples of how liquidity ran dry well before a company anticipated was at Halcon Resources (HK). For example, in July of 2015, CEO Floyd Wilson stated that "we have the liquidity necessary to execute our business plan and service our debt for the next several years." That said, of the $902 million of liquidity it had at the time, less than $10 million was cash, with the rest consisting of the availability under its credit facility. That was a problem because Halcon's banks could reset its borrowing capacity twice each year based on the value of its oil and gas reserves, which fluctuates with oil prices.
With oil prices still crashing in early 2016, Halcon estimated that banks would cut its borrowing capacity down to between $650 million to $700 million, which was a growing problem given that it was outspending cash flow to survive. Banks did end up cutting its borrowing capacity to $700 million in the spring, which left it with just $555 million of liquidity. With its liquidity quickly evaporating, and no signs of improvement in the oil market, the company ended up filing for bankruptcy in the summer of 2016 to wipe out some of its debt so it could breathe. It's a situation that never would have happened if Halcon didn't rely on its credit facility for liquidity but instead had an emergency cash stockpile to keep it afloat. The lesson here is that I no longer count a company's credit facility as an asset but see it as a potential liability that could lead to its downfall.
No. 3: Trust but verify what management teams say
One of the more disheartening sights of the downturn was watching the credibility of management teams crumble because they made promises they could not keep. The one that sticks out the most because it still stings a bit was ConocoPhillips' (COP -1.80%) assurance that it could maintain its dividend even though oil was in a freefall.
Throughout 2015, the company's management team hammered home that the dividend was unshakable. CEO Ryan Lance even pounded the table on one of the company conference calls, stressing that "the dividend is safe. Let me repeat that. The dividend is safe." Further, the company's CFO said that the payout was the company's "top priority" and that management's view was that they see a "dividend as something that really should only go one direction ... to grow it over time." I bought into management's promise quite literally by adding to my position because I believed they would keep that promise to investors.
However, while management said the dividend was safe, ConocoPhillips' cash flow said otherwise since the company was outspending it by a wide margin, causing debt to rise. That ultimately caused the company to wave the white flag and slash its payout 66% in early 2016 to stop the bleeding. That move turned out to be a prudent one because it has helped reduce the company's cash flow breakeven level from more than $75 a barrel to less than $40 a barrel, which puts it on a much stronger financial footing.
That said, the lesson here is that a company's financial metrics need to back up what management says, otherwise those are empty words.
This education cost too much to waste
We all make mistakes, but the real failure is in not learning from them. While my investing mistakes leading up to and during the oil market downturn cost me dearly, that expensive education taught me some valuable lessons that will make me a better investor in the long run. That said, I'd still like to spare you from paying such a high tuition in hopes that you'd learn these lessons from me instead of paying up to learn them later by making the same mistakes yourself.