It's probably an understatement to say that 2015 was not kind to the energy industry. Ever since oil and gas prices started to decline 18 months ago, shares of energy companies have been on a consistent slide. With 2016 on the horizon, many investors are hoping that some energy investments can do an about-face and start to recover all of the losses from this past year.
So we asked three of our contributors to highlight a company that has the potential to recover in a big way this coming year. Here's what they had to say.
Kinder Morgan's (KMI -0.06%) shares are well off their recent highs. The reason? Moody's recently announced that it was changing its outlook on Kinder Morgan's debt to negative, while still affirming that debt as investment-grade. Kinder Morgan's sin? Acting as something of a "white knight" to extend its ownership share in the struggling NGPL pipeline, thus increasing Kinder Morgan's net debt leverage.
Kinder Morgan is largely in the business of moving energy around. While it does have some exposure to commodity prices, 86% of its cash flows come from fee-based operations, and for 2015, 95% of cash flows are either fee-based or hedged. On top of that, 79% of the oil production part of its carbon dioxide-related business (the major part of the company exposed to commodity price swings) is hedged throughout 2016.
Even when announcing that negative outlook, Moody's acknowledged that only around 10% of Kinder Morgan's cash flows are exposed to market volatility. Additionally, Moody's indicated that the key issue is that Kinder Morgan's adjusted debt-to-EBITDA ratio will be around 5.9, which is slightly above the 5.8 level that Moody's would consider acceptable for a "stable" outlook.
It's true that until very recently, Kinder Morgan indicated that for 2016 it expected to increase the cash flow it could potentially use to pay dividends versus 2015 levels. Because of the debt rating brouhaha, however, Kinder Morgan instead elected to slash its dividend by about 75% in order to maintain a stable credit rating.
The dividend cut is a short-term shock to investors who had come to rely on the pipeline giant for both current income and dividend growth. But when all is said and done, Kinder Morgan remains a solid company without huge exposure to commodity price swings. Even before the announcement, Moody's expected that Kinder Morgan would still generate strong cash flows and not be at any real risk of violating any debt covenants.
The upshot of all this is that while Kinder Morgan's shares have taken a beating due to its increased leverage, its fundamental operations haven't substantially changed. While there remain no guarantees in the stock market, that same stock market values companies based on their forward-looking prospects. With the dividend cut now in its past, the market can now focus on Kinder Morgan's future.
With its fundamentals largely intact and in many ways stronger thanks to the dividend cut, that future still looks solid. That's what makes Kinder Morgan look very much like the definition of a beaten-down energy stock with a potential to rebound in a big way in 2016.
One company that seems to have a lot of rebound potential is Denbury Resources (DNR). I should be clear, though, that a rebound is based on the corollary that we see some uptick in oil prices.
The reason that Denbury looks rather compelling compared to so many other exploration and production companies is that management has acted in a much more conservative manner than its peers'. A vast majority of its oil production comes from enhanced oil recovery methods that repressurize old oil reservoirs with CO2. The benefit of getting oil from these sources is that they have much lower decline rates than shale, which requires much less maintenance capital. This means that it has been able to keep spending levels very low so far this year and has been able to come close to breakeven pricing at $45 per barrel.
Unlike other U.S.-based oil and gas producers that likely need much higher prices than that to get by, Denbury only needs a modest recovery in oil prices to turn back into the black. Also, the company has kept its financial house in order much better than its peers have.
Some investors are likely shying away from Denbury Resources right now because of fears that it's protecting its earnings with oil price futures contracts that will start to roll off in 2016, but if oil prices were to recover and the company shows it is modestly profitable at lower prices, then investors might get interested in this stock again. With shares trading at one-third of tangible book value, a small sign of strength could send shares bouncing back in a big way.
Seadrill (SDRL) is one of the few stocks I've chosen to sell this year, recently selling off the majority of my shares about a month ago. It's also a company I don't particularly have much faith in at the moment.
So why am I writing about it as a potential "big rebound" candidate for 2016? Because it's important to see how much risk the company faces, as well as what that risk is made of, in order to understand how it could bounce back.
Seadrill has some advantages, including one of the biggest contract backlogs in the industry and an ultra-modern, high-spec fleet, and is one of the best-regarded operators in terms of safety and efficiency. However, the company's massive debt outweighs its backlog considerably, and Seadrill is just now starting to feel the pinch of the downturn as contracts expire without replacements lined up for some vessels, and much lower dayrates for others. At some point, the situation could become untenable, with Seadrill not finding enough work to cover its operating and debt costs.
And while it's probably unfair to say that is imminent, it can't be ignored. This has become a much more protracted oil downturn than anyone could have expected, and it's hard to see an easy path forward for the offshore driller if oil prices don't recover fairly soon.
But if -- and this is a huge if -- oil prices do start to recover in 2016, offshore oil producers could start loosening their purse strings. If that happens, there's no doubt that Seadrill would be a big bounce-back stock.
The problem is, nobody can do more than guess when the recovery will happen. And since an investment in Seadrill today is a bet on oil prices recovering, it's essentially speculating on a guess. And that's something energy investors need to recognize before taking on that risk.