Not only do falling prices make it difficult for oil and gas companies to operate, they're also wrecking balance sheets. That's because more than a few players have had to take on unsustainable levels of debt just to stay afloat.
We're now starting to see companies like Penn Virginia and Magnum Hunter Resources buckle under the pressure. In this video segment, our energy team takes a look at the current situation, and the lessons to be learned from it.
Listen to the full podcast by clicking here. A full transcript follows the video.
Sean O'Reilly: Oil's still in the $40s; things are not looking good for 2016. We talked about defaults before, but is every company but Exxon and Chevron going to go under before this is over?
Tyler Crowe: That might be pushing it.
Taylor Muckerman: Just a little bit.
O'Reilly: I like to speak in hyperbole for comedic effect.
Crowe: That is quite the hyperbole. But one of the things...
Muckerman: That would solve everyone's problems in 20 minutes or less.
O'Reilly: It would. Cure for low prices is low prices, baby.
Crowe: You know, we talked about this, when was it?
O'Reilly: Two months ago.
Crowe: January. Well we've talked about it a lot. We've talked about it in November, we've talked about it in January, we've talked about it in March.
O'Reilly: But we mean it this time, darn it.
Crowe: I think one of the reasons that we haven't seen that reaction of defaults and people getting in financial trouble is, well, in all honesty, two things: One, I think a lot of people expected oil prices to be a little bit more robust than they are right now. I mean, if we go back to November-December, you hear all these wildcatter-style CEOs and guys like Pickens and stuff like that. We'll be at 70 by, in six months or ...
O'Reilly: ...end of the year.
Crowe: End of the year, we're back at 70, and y'know, everybody kind of hung on to that, and be like, "Okay, we'll get through this. This sucks, but we'll get there." And we're what, 45...
O'Reilly: It's almost Thanksgiving.
Crowe: ... 45-50 days from the end of the year, and we're still below 50. It's starting to really weigh on a lot of these people who thought they could weather a short-term storm, and well, that storm is a little bit longer than they expected.
In so many of these players that we had talked about, we knew they were going to be in trouble when oil prices were low. You looked at their balance sheets, you saw they had taken out a ton of debt, but at the same time, I guess they just held on for a little bit longer and everybody expected it. I guess people are more resilient in that fact where they want to say, "We'll hang on. We'll hang on. We can make it through."
O'Reilly: Well, and the other reason that pain hasn't been quite felt is hedges, of course.
Crowe: That has helped to a certain degree. There's a lot of companies that have that in place, especially when you look at, let's say Master Limited Partnerships that are in production. They have those hedges to kind of steady out their cash flows; but at the same time, there's a lot of people who didn't have that, have just had to slash their capital budgets, their operating expenses down to the absolute floor to make it as profitable as possible.
Some have been able to achieve some marginal level of profitability, which is quite commendable; but at the same time ,when you, again going back to their ability to pay off debts, it's getting a little bit harder.
Muckerman: I think some of the people that are facing these defaults probably didn't utilize hedges that much because they were those guys that were just saying, "Why are we going to forgo profits now with these silly hedges. This is going to crimp our returns now. Who knows what the future holds? What if oil prices stay at $150? These hedges are going to just, they're going to ruin our stock price."
O'Reilly: Was it Harold Hamm that cashed in his hedges a year ago now?
Crowe: Yeah, right about.
Muckerman: So like I said, looking at these companies, you're talking about some names that were really popular names among investors, among the energy inner circles during the last four to five years of the boom leading up to November of last year. And now, all of a sudden, their debt is essentially worthless. At least that's what they're predicting in the next few months.
Penn Virginia I think is coming up on some covenants. Magnum Hunter Resources -- they mentioned in the report that Tyler sent around, is basically already defaulting. And those two companies, while they're not huge, they're only domestic EMPs, but those are some hot stocks. Those were very, very popular, and now they're reaching ...
O'Reilly: So it was a little at 45 just because everybody's been holding on.
Muckerman: It's below 45 right now. It's almost 42.
O'Reilly: Oh yeah, it's 42, 43. Is it just holding on? I mean, you see inventories continuing to creep up, but production is falling. Is it just people putting it there because they don't want to sell it at 45?
Crowe: Well, I mean again, to these companies, they have to generate cash to pay these loans off to a certain event. So they can't just shut off the taps. Especially like you said, Penn Virginia and Magnum Hunter...
Muckerman: Magnum Hunter, the article said that they have debt coming up this month that they can't pay.
Crowe: So these companies, they can't turn off. They can't just stop producing because they need cash now. It's like those dumb annuity commercials. They always say, "I need cash now." But right now, there's just too many of them out there.
O'Reilly: If only there was a payday lender for oil companies.
Crowe: There were and now...
O'Reilly: Oh yeah... it's called Wall Street.
Muckerman: There were. Now it's gotten to the point where not even payday lenders won't toss them a bone.
Crowe: And so, with those people that aren't in that flexibility to say, "Well we just can't stop drilling." Or, "We can't stop producing." It kind of has compounded the issues that we have seen so far.
I mean, obviously, you've got some of the larger, more well-capitalized companies, the EOG Resources, ConocoPhillips people like that, who have scaled back and said, "We can..." Even though some of them are more profitable at much lower prices today, they're still scaling back and saying, "You know, we can take our foot off the accelerator for a little while."
Muckerman: And that's not because they're smart now; it's because they were smart before. They weren't taking on these crazy amounts of debt. They weren't drilling out of control. It's kind of a dominoes affect here with these companies that they're able to do this because they were smart five to 10 years ago when they were first realizing that this is a gold mine; but it's not going to last forever. Because hey, the energy industry is...
Crowe: It's a cyclical business.
Muckerman: Yeah. They got it and some companies that didn't -- it's evident every time the bottom hits or comes close. Some companies just didn't have the experience or the wherewithal to pace themselves.
Crowe: And certainly, as investors and people like us that couple years before, it was kind of one of those starry-eyed sort of moments where we looked at it and said, "We can take control of the market back where we can produce all of our own oil."
Muckerman: Energy independence.
Crowe: Energy independence. And seeing these companies that were just growing at gangbuster-like levels almost doubling production every year, it sweeps you up. It really does as an investor, and you see all these companies that are just growing so fast, and you want a piece of that. But at the same time, again going back to the fact that it's a cyclical business, if you're an investor in this space, certainly a lesson I learned, in some ways the hard way from this one, is that we have to be measured in our approach throughout this entire -- through the down market and through the up markets.
That last one? We all got caught up in it, and it probably burned quite a few people. And today at the same time, don't overlook the fact that there's a lot of value in buying solid energy companies today. Don't just get burned back then, and now today, completely go away from energy. Because there are some opportunities out there. And when this market does turn -- it will eventually -- when it does, you'll have some -- I think there's a great opportunity for some long-term rewards.
O'Reilly: So before we move on to this bottom line, it seems like some companies have got to die for production to really drop. I mean is that basically what we're saying here?
Muckerman: The crematories are firing up their furnaces.
O'Reilly: OK, that's dark but true.
Muckerman: Using oil to fire up their furnaces.
Crowe: Cheap, cheap oil.
O'Reilly: No, no, no, natural gas.
Crowe: Either way, they're both cheap.
Taylor Muckerman has no position in any stocks mentioned. Tyler Crowe owns shares of ExxonMobil. The Motley Fool owns shares of EOG Resources and ExxonMobil. The Motley Fool recommends Chevron. 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.