Shares of U.S. onshore oil and natural gas driller SM Energy Company (SM 1.59%) jumped as much as 17% on June 1, rising throughout the morning and into the early part of the afternoon. By 2 p.m. EDT, that stock was sitting just off the day's highs. The energy company's balance sheet was the big story of the day.
At the end of the first quarter, SM Energy's debt-to-equity ratio was nearly 1.15 times, which isn't terrible for a company that operates in a stable industry. However, SM Energy drills for oil and natural gas, which is a highly cyclical business. The worldwide effort to slow the spread of COVID-19 has pushed energy prices down to historic lows as economies around the world basically shut down. SM Energy and many of its peers are struggling. SM Energy, specifically, lost $3.64 per share in the first quarter. In the midst of a deep industry downturn, investors have been quite reasonably worried that the company won't be able to carry the weight of its debt.
So on June 1, when the company announced that it had come to terms with certain lenders on a debt exchange, which will act as a backstop to the company's larger debt exchange efforts, investors reacted as you might expect: positively. This is good news in that with the effective blessing of these lenders, the full proposed debt exchange looks more likely to get completed. More importantly, these efforts, assuming the debt exchange is fully completed, will provide SM Energy with some much-needed breathing room to work through the industry downturn.
However, investors should take the news with a big grain of salt. For starters, the company had to issue the investors who have agreed to backstop the bigger deal warrants to acquire up to 5% of the company's stock. That's a generous enticement that hints at how desperate the company is to get this deal done.
Second, the new notes will require SM Energy to pay a 10% interest rate. That's a very big number that will weigh on the company's ability to generate the cash it needs to survive over the longer term. In exchange for the higher coupon, meanwhile, the new debt will come with more relaxed protective covenants.
That's really the big prize for SM Energy, noting that, according to the news release, the bond holders agreed "to eliminate substantially all of the restrictive covenants and certain of the default provisions contained" in the old notes. The higher coupon is there to compensate for notably higher risks.
It's good news that SM Energy looks as if it will be able to refinance its debts and relax the restrictive covenants it now has to live within. However, the costs here are material for both the company and debt investors. Without higher oil and gas prices, SM Energy's financial situation will likely remain precarious. Investors, meanwhile, need to remember that in a bankruptcy situation, they are in line to get paid behind basically all other creditors -- most notably bondholders. Despite the positive news, this is a high-risk turnaround stock only appropriate for aggressive investors.