Whenever there's a major downturn in a market or a sector, there are always a bunch of investors who go bargain hunting. The idea is that by buying these stocks at severely depressed prices, investors can get more bang for their investing buck at these cheap prices. While there are lots of reasons that support the concept of value investing (see: Benjamin Graham and Warren Buffett), there is one drawback: Some of those stocks with severely depressed prices are there for a reason beyond market sentiment. These are what you would call value traps, an investment that looks like a value at today's prices but will probably end up still getting much worse.
Energy stock prices have taken a turn for the worse over the past year, and so one hot place to look for value investments is in that space. So we asked three of our energy contributors to warn investors of a stock they see as a potential value trap. Here's what they had to say.
Matt DiLallo: In a sense, it's tough to call any energy stock a value trap at this stage, because a strong rally in the price of oil will take the whole industry higher. Having said that, there are some energy stocks that will continue to struggle even if oil prices are higher. Topping that list, in my opinion, is Brazilian energy giant Petrobras (NYSE:PBR).
There is a case to be made that Petrobras is a value, as its stock price is down 94.5% off its historic high. Not only that, but it's also sitting on billions of barrels of oil, having proven reserves of 16.57 billion barrels of oil equivalent. It has much more oil beyond that because of its strategic position offshore Brazil. While that oil isn't as valuable today as it was last year, it's still a very valuable commodity.
Still, this company is just a mess. It's still in the midst of a massive corruption scandal that at the moment is an open-ended liability. Worse yet, it's sitting on more than $100 billion in outstanding debt that was just downgraded to junk by the rating agencies making it the largest issuer of junk bonds. On top of all that, its cost structure is bloated, as the offshore oil it produces is more expensive to produce.
There's a real risk that the Petrobras story could end badly, as lower oil prices for an extended period of time could be disastrous for the company and investors. However, even if that scenario isn't in the cards, it will be hard for the company to really create a lot of value, given that debt is what it uses to fuel growth. That's simply not sustainable over the long term, as debt has proved time and again to be a trap that continues to ensnare investors.
Jason Hall: This one's easy for me: Seadrill, Ltd. (NYSE:SDRL), because so many people will make the mistake of seeing its recent earnings "beat, and think the stock looks way too beaten-down at recent prices.
The problem with that approach? It simply ignores how much of the company's recent result is a product of long-term contracts, many of which will be expiring over the next year, and a lack of future backlog to replace the income that will be drying up over the next 18 months.
Offshore drilling is in a shambles right now. Too many rigs are still operating, competing for too little work, and that reality isn't expected to change in the next six months or year. It's likely to be even further exacerbated by the innovations in onshore drilling that have significantly reduced to cost of producing from so-called "tight" shale formations.
There have been no similar innovations to drive down the cost of offshore drilling.
To the contrary, much of the world's offshore reserves are likely to be even more expensive than past production, since they are generally located in deeper water, and in more extreme environments, such as the Arctic.
Don't get me wrong: I believe that oil prices will eventually rebound, and that offshore oil production will be a necessary source of energy. But a full recovery in offshore could take years, and Seadrill's huge debt load and shrinking backlog create way too much risk and uncertainty to call the company anything more than a risky bet, no matter how "cheap" the stock looks today.
Tyler Crowe: Over the past five years, shares of Peabody Energy (NYSE:BTU) have slid more than 98% off of their high. Something dropping that much will have even the most pessimistic person saying to themselves that it can't go much lower than this. Looking that the company's recent results, though, it could well go even lower than where it is today.
What makes this one such a value trap is that there are enough reasons to make you believe it's a compelling value investment. The first is that Peabody is in the coal business, a notoriously cyclical business. With more than 130 years in the business, the company has weathered storms before. Also, as the nation's largest coal producer, it's easy to assume that the company would have the economy of scale to outlast its competitors. On top of that, we've seen that big-name investors such as George Soros may have taken a token position in the company, which can trick us into thinking that someone like Soros is bullish on the company.
The fact is that Peabody is facing two major headwinds to its business: a market in structural decline, and upstart companies that are beating it to the bottom of the cost curve. Ever since shale gas started to become economically viable in the U.S. around 2009-2010, we have seen natural gas prices decline significantly. This cheap new energy source has therefore been able to take some of coals business away from it. Add that to aging coal plants that are getting shut down without new ones being built, and coal's slice of the electricity pie is getting smaller by the day.
What's making things even worse for Peabody is that there are a small handful of coal companies that are very profitable today. These coal miners in the Illinois Basin have lower transportation costs than Peabody's Powder River Basin coal, and without lots of legacy mine costs they can undercut much of Peabody's pricing power from the Powder River Basin. If these new mines can grow production and be profitable while undercutting Peabody's prices, what can Peabody do?
It will take a lot to go Peabody's way if it is ever to crawl out of this hole, but the market conditions out there suggest that it will take a long time for it to happen.
Jason Hall owns shares of Seadrill. Matt DiLallo owns shares of Seadrill. Tyler Crowe owns shares of Seadrill. 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.