#$egy

A few months ago I traveled to Houston and wrote about the increasingly upbeat mood I encountered at the energy companies I visited there. I came away from that trip thinking that well-managed service and exploration firms might be attractive investments. Many had declined 40-60 percent in response to oil’s decline from $104 last summer to the low-$40s by late fall. As oil prices rose past $60 this spring, I suspected these stocks could eventually rally.

So much for that idea.

Earlier this year, Sabine Oil and Gas, Warren Resources, Quiksilver, and rig operator Hercules Offshore filed for bankruptcy. Last week, Samson Resources and Sandridge moved close to restructurings, as well. Other public energy companies close to bankruptcy include Halcon Resources, Energy 21, Swift Energy, Comstock Resources, Goodrich Petroleum, and EV Energy Partners, LP. The list goes on and on, and it’s likely to grow.

This fail parade is not solely due to low oil prices, however. It’s the predictable result of a problem endemic to the energy business: an absolute inability to say no to Wall Street debt financing. Borrowing money from Wall Street is a crippling addiction that has afflicted this industry for as long as I’ve been studying it. Until oil and gas executives learn to follow Nancy Reagan’s advice and Just Say No when Goldman Sachs and other big brokerages come calling with fee-rich debt deals, they will continue to drill their companies into oblivion.

As a general rule, the grander the ambition, the greater the balance sheet leverage—and nobody outdoes the energy industry when it comes to grand ambition. The vast majority of publicly traded energy companies incur capital outlays in excess of their annual cash flows. Wall Street happily encourages this destructive behavior by arranging one bond offering after another during industry uptrends. Why managements and Boards approve these potentially disastrous financings is simple: overconfidence. They convince themselves that they will grow faster than their peers, so they eagerly borrow and outspend their cash flows and rarely, if ever, give cash back to investors via quarterly dividends and/or share buybacks. Of course, this doesn’t stop the same Wall Street firms who arrange all that borrowing from covering and—more often than not—recommending their stocks.  

A few weeks ago I met the chief financial officer of Denver oil firm Bill Barrett Corp (BBG). His stock was $9 then, down from the mid-$30s in 2013. It’s now below $5. Not surprisingly, Barrett has public debt, courtesy of Wall Street investment banks, which in a worst-case environment could tip the firm into a restructuring. This is a business with $472 million in revenues last year, and yet a staggering 18 Wall Street analysts cover it. Gee, I wonder why. Compare that to one of my favorite non-energy stocks of late, Calavo Growers (CVGW), a company with $1 billion in annual revenues and virtually no debt. For most of its history, Calavo has been followed by no more than three Wall Street analysts. A fourth recently initiated coverage.

The balance sheets of most Silicon Valley firms are the polar opposite of energy operators. Apple, Google, Microsoft and most software/internet companies have loads of cash and little, if any, debt. In recent years many Silicon Valley companies have started quarterly dividends and buybacks, instead of throwing their full annual cash flows (or more) into R&D efforts.    

It might not be as bad out there as you think.

Earlier this week, I spent three days in New York City at the annual IPAA (Independent Petroleum Association of America) Conference.  Like most people, I've been leery of energy stocks in recent months. But I left the conference with a different mentality.  

As unlikely as it seems, it might be time to go bargain hunting in the oil patch.

Don't get me wrong. The energy sector is a long way from a sustained recovery, so investing in smaller, independent oil and oil-related companies is still a very dicey proposition. But if you pick your spots wisely, you can find some winners at prices we may never see again.  

The first thing to do is figure out who not to buy. Oil services stocks have been pummeled. Many are down over 60 percent in the last 12 months. At first blush, some might seem oversold. But new drilling activity has been cut in half (the latest Hughes rig count has dropped to almost 700 versus more than 1500 last year) and company reps at the conference conceded that the prices services firms can charge are down up to 35 percent along with it. A third less revenue for half as much business isn't exactly the recipe for a strong rebound. Buyer beware.

The exploration and production space is far more promising. Once a well is successfully drilled and is producing hydrocarbons, the incremental cost to produce each barrel is relatively small. Better still, many of these companies have hedged their production for most of 2015 and some of 2016 at higher prices than today’s mid-$50 levels. Moreover, on a macro level, I am not nearly as bearish on oil prices as most people these days.  

Finding oil is expensive, and unless Saudi Arabia opens the spigots and swamps the markets, I believe prices will inch higher as worldwide economic growth spurs increased consumption. All told, the world consumes about 92 million barrels of oil a day. Three nations– Russia, Saudi Arabia, and the good old U.S. of A.--produce about 10 million of those daily barrels each. All of them have the capacity to produce more, but little incentive to do so until prices get a whole lot higher. As existing wells go dry over the next few years, worldwide supplies will tighten--and wells in shale formations, which made up the bulk of the recent energy boom in America, deplete faster than traditional wells, so that supply contraction should accelerate.  

Add it all up and E&P is definitely worth a look, with one crucial caveat: debt. Too many energy companies have leveraged balance sheets, as the industry has a bad habit of borrowing lots of money and plowing that cash into exploration during boom times. I don't know the exact numbers offhand, but I would bet over 80 percent of all US exploration firms spent more on capital expenditures than their operating cash flows in recent years. That means a lot of them are seriously underwater now. Again, buyer beware. With that said, some names stand out as possible buys. Vaalco (EGY), Pioneer Natural Resources (PXD), Northern Oil and Gas (NOG), and Cimarex (XEC) have all come through the bust with relatively healthy balance sheets and yet their stocks are all closer to 52-week lows than 52-week highs.

Finally, stock pickers like me aren't the only ones scouring the bottom of the oil sector for discounts. With market caps lower than they've been in years, I expect acquisitions to pick up steam as larger energy players look to snap up their smaller competitors. They'll be looking for cheap, profitable businesses with low debt loads, too--and they should be willing to pay a nice premium to acquire them.