#$exxi

Two high profile commodity companies filed for bankruptcy last week. The first was St. Louis-based coal producer Peabody Energy (BTU). Peabody was the latest coal producer to file, following Arch Coal, Alpha Natural Resources, Patriot Coal, and Walter Energy. BTU quickly fell below $1 on the news. Just a few years ago, Peabody’s market capitalization exceeded $20 billion. On Wednesday, Houston offshore oil producer Energy XXI (EXXI) joined Peabody in bankruptcy court. Four years ago, EXXI was a $32 stock. On Thursday, the day after it announced its bankruptcy filing, it closed at 12 cents.

When the end comes, it comes quickly.

There are two reasons these companies fell from grace so precipitously. First, their revenues cratered as the prices of their primary products collapsed. Second, both companies are loaded to the gills with debt. Lots of debt. Specifically, Peabody has roughly $5.5 billion of debt outstanding, while Energy XXI has about $5 billion. Once revenues began to fall, and fall steeply, it was only a matter of time until BTU and EXXI crumbled under those onerous obligations.

I’m always dumbfounded by the buoyancy of troubled stocks like EXXI and BTU as they approach a bankruptcy filing. In recent weeks, both traded well above $1. Shockingly, Peabody was a $6.55 stock only one month ago. While retail and other investors were buying these dogs, the publicly traded debt of each company was plummeting, and rating agencies and credit analysts—who usually do a better job analyzing companies than stock analysts—were warning investors about impending doom.

Given these clear signals, why were BTU and EXXI (and countless troubled stocks before them) able to remain overvalued right up until the moment they went broke? And why did both companies willingly saddle themselves with killer debt loads to begin with?

The answer to the second question isn’t complicated: borrowing money is way too easy in the corporate world. That’s because facilitating debt deals is way too profitable for Wall Street. Ivy League-educated investment bankers are experts at convincing CEOs and company Boards to raise money via bond offerings.

The answer to the first question is a little more involved. Put simply, investors, as a group, overlook the dangers of debt on a company’s balance sheet. Two stocks outside of the commodity space illustrate this point. Both Twitter and Tesla have taken on billions in debt in recent years, and yet nobody seems to have noticed, or care. Despite the fact that Twitter is sitting on nearly $3.5 billion of cash, the company sold almost $2 billion of convertible debt in 2015. Last year, Twitter paid almost $100M in interest on those bonds. Tesla reported $2.6 billion of debt and $1.2 billion of cash on its year-end balance sheet, and paid $119M in interest in 2015. Meanwhile, GAAP losses at both companies in 2015 were enormous: Twitter lost $521M and Tesla lost $889M. While both reported much better ebitda amounts—Twitter’s was $558M, while Tesla lost “only” $294M—they both had large capital expenditures. Tesla spent $1.6 billion; Twitter, inexplicably, spent $347 million. If either company has an unexpected revenue slowdown or recall, they might deeply regret borrowing those billions.

Investors may underestimate the perils of high debt loads because our society itself does so. Homeowners are encouraged to take on mortgage debt. Most cars are bought with borrowed money. Student loan debt now exceeds $1.2 trillion. Outstanding debt on credit cards—which usually charge high, double-digit interest rates—is about $1 trillion. The Granddaddy of all borrowers, of course, is Uncle Sam. Our nation’s outstanding debt is approaching $19 trillion, up from about $10 trillion only eight years ago. Someday, possibly before I go to the giant credit bureau in the sky, folks worldwide might stop buying America’s short duration debt and our 10- and 30-year bonds at today’s all time low interest rates. That would be an economic disaster. As a country, we spend $600 billion/year servicing our national debt. If we were forced to pay much higher interest rates to borrow, that number could easily rise to $1 trillion or more, which would “crowd out” spending on defense, entitlement programs, and so-called discretionary items (government agencies, schools, infrastructure projects, NASA, etc). A severe recession and a lower standard of living would follow. Borrowers—and investors in stocks with excessive debt— beware.

Ever since oil cratered to $26/barrel on February 11th, prices have steadily inched higher. West Texas Intermediate has now climbed into the $40/barrel range. Not surprisingly, energy stocks have kept pace, with many service companies and independent producers hitting year-to-date highs. Unfortunately for some energy firms, however, this recovery will probably be too little, too late.

Unlike other sectors, it is pretty easy to identify which energy companies will survive and which will likely file for bankruptcy. Because many energy firms have public debt, bond prices and bond yields can be extremely useful predictors of a company’s future stock price. The higher the yields, the stronger the likelihood a business is heading toward bankruptcy. Once bond yields surpass 50 percent, the chances of a default and reorganization approach near certainty.  

Today there are a handful of energy companies with bonds yielding 50 percent or more. This includes Basic Energy (BAS), Gastar (GST), Energy 21 (EXXI), Exco Resources (XCO), Stone Energy (SGY), and W&T Offshore (WTI). Others, like Ultra Petroleum (UPL) and Linn Energy (LINE) have already missed interest payments on their debt, which is almost always a precursor to a bankruptcy filing and a zeroed out stock price.  

The reason bond yields are such reliable indicators of financial distress is quite simple: buyers and sellers of corporate debt are not speculative day traders betting on long shots. They are mostly sophisticated, accounting-savvy institutional investors and hedge funds. They have to do be right more than they are wrong or they lose their jobs.

Conversely, investors in low priced stocks – especially retail investors – are often far less rigorous in their research and investing approach. Proof of this fact can be seen in the recent performance of the eight stocks I listed above. Despite the staggering yields on their bonds, almost all of them have seen their stock prices rally in recent weeks.

After three decades in money management I increasingly doubt whether John Q Public understands the implications of a Chapter 11 filing. I also wonder if senior managements (and their cheerleaders on Wall Street) instill a misguided fear of bankruptcy in workers and politicians. Why? Because financial elites know that bankruptcy always wipes out a stock price and hurts bond prices, as well. They also know that while bankruptcy reorganization rarely causes the widespread loss of jobs, it devastates the net worth of senior management, large investors, and sometimes Board members. In their eyes not all stakeholders are created equal.  

If Shell's $70 billion purchase of BG Group reignites interest in the battered sector, Energy XXI, W&T Offshore and Stone Energy will attract most of the attention.

by Claire Poole

Oil and gas explorers and producers that work on the land have it easy: They can move in and out of wells quickly when prices fall or when they find better prospects elsewhere.

Offshore operators aren't as lucky. They have to build a lot of infrastructure -- in the water, no less -- to pursue their quarry. So moving in and out of wells takes a lot of time and a lot of money: the typical deepwater project can cost $1 billion or more, most or all of which would be spent over a five-year period before any returns are seen, according to petroleum industry adviser Gaffney, Cline and Associates. "As a result, projects currently underway are less likely to be stopped," said Bob George, an executive director and senior strategic adviser at the firm.

That's one of the reasons why companies like Energy XXI Ltd. (EXXI), W&T Offshore Inc. (WTI) and Stone Energy Corp. (SGY) have been punished so severely in the stock market after the dramatic drop in oil prices. Energy XXI, for example, is trading 83% off its 52-week high, while W&T's stock is down 70% and Stone's shares have declined 66%. Some observers think their troubles could force them to sell assets -- and perhaps themselves. "They are the tail end of the whip," as one industry watcher put it recently.

Royal Dutch Shell plc's $70 billion purchase of BG Group plc -- a deal that gives the buyer access to arguably the best deepwater oil resource globally in Brazil, according to Tudor, Pickering, Holt & Co. Securities -- could very well spark some M&A among companies operating offshore. "Shell's move ... is likely to reignite interest in a moribund space," Tudor, Pickering, Holt said.

Houston-based Energy XXI, led by John Schiller, probably didn't have the best of timing when it bought EPL Oil & Gas Inc. last year for $2.3 billion, which happened before oil prices began to slide and loaded it up with debt. Industry sources say the company hasn't been able to sell its shallow water assets in the Gulf of Mexico for a price it liked (bids came in at year-end and it was hoping for $300 million to $350 million). But it was able to raise $1.25 billion in a private senior notes offering to repay debt on its revolver, which bolstered its liquidity, and to amend its revolver, which provided some covenant relief. Global Hunter Securities Inc. analyst Mike Kelly said he remains on the lookout for the company's sale of its Grande Island pipeline assets, which could bring in an additional $250 million to $300 million.

However, Moody's Investors Services analyst Amol Joshi noted that the additional secured debt further subordinates Energy XXI's unsecured debt and exacerbates its already high leverage and interest expense burden. "While the company continues to pursue asset sales to stabilize its liquidity further, the company's balance sheet remains highly-levered and reduced capital spending could impact its production and Ebitda," he said.

Meanwhile, W&T Offshore, which is led by Tracy Krohn and has picked up assets from Shell, Woodside Petroleum Ltd. and Callon Petroleum Co. (CPE) over the years, has been trying to survive by repositioning itself. The Houston-based company cut its capital expenditures by 70% and has been shopping its Permian Basin assets in West Texas to focus on its deepwater developments, according to one analyst. But those properties aren't considered the core of the play, which has made it more difficult. "The bid-ask remains wide ... [and] any M&A that occurs will be in the core areas of the key resource plays," the analyst said. W&T bought the properties from an unnamed seller in 2011 for $366 million.

Stone Energy, led by CEO David Welch, also took drastic measures by suspending operations in Appalachia for the rest of the year. It could sell those assets (there's been talk about a joint venture with another company), but it could also sell down part of its Amethyst discovery in the deepwater Gulf of Mexico to bring in cash. Bankers have been talking about that idea and others to the Lafayette, La.-based company, according to people familiar with the situation.

There are some large companies out there ready to do some deals. The super-majors -- including ExxonMobil Corp. (XOM), Chevron Corp. (CVX) and Shell -- have the cash on hand to easily pick up assets as well as whole companies. They also have a longer time horizon that is inherent in offshore, particularly deepwater, projects. While many got out of the Gulf of Mexico shelf earlier in the decade (ExxonMobil sold its assets to Energy XXI in 2010 for $1 billion), they already operate in the deepwater there and could easily incorporate some shelf assets on the cheap and capture some synergies.

Private equity firms could also play a role. Riverstone Holdings LLC-backed Fieldwood Energy LLC has been consolidating in the Gulf of Mexico shelf in recent years with its asset acquisitions from Apache Corp. (APA) for $3.75 billion and SandRidge Energy Inc. (SD) for $1.1 billion. Apollo Global Management LLC-backed Talos Energy Offshore LLC bought shelf properties from Stone in July of last year for $200 million (Riverstone is also an investor). There's also Venari Resources LLC, which Warburg Pincus funded in 2012 with $1.13 billion.

The quick fix, of course, is for offshore companies to halt their exploration efforts, focusing only on the production side until oil prices improve. Some already are. BP plc, for example, recently canceled contracts on rigs owned by Ensco plc (ESV) and Seadrill Partners LLC (SDLP). The service providers didn't make out too badly: Ensco is getting a $160 million fee for the year left on its contract, or 78% of potential revenues, while Seadrill Partners' West Sirius is getting $160 million for almost 800 days, according to Raymond James. The news surprised its analyst Praveen Narra, who wrote in a recent report that he thought that deepwater Gulf of Mexico would be relatively strong as existing contracts would have led to a flat rig count year-over-year. "BP's desire to cancel the contract in spite of having to pay a high fee is indicative of the lack of work to be done," he said. "It is further evidence that the region [the Gulf of Mexico] is not immune." Tudor, Pickering, Holt agreed: "BP [is] a notable E&P operator in this important deepwater theatre, so [the] fact that they're paying up to early terminate two high-specification floaters speaks volumes regarding lack of near-term deepwater rig demand."