Three Steps to Avoid Sinking Ships in Oil’s Rising Tide

Matthew Carr By Matthew Carr
Emerging Trends Strategist, The Oxford Club

Oil & Gas

We’re all familiar with the market adage “A rising tide lifts all boats.”

It’s the idea that a strong, bullish market will keep even the leakiest or overweighted boats afloat… at least for a little while.

But ultimately, a sinking ship will sink, no matter how high the tide gets.

Over the past two years, the price of crude has roared higher…

From its lows in February 2016, oil is up 148%.

On the surface, that appears like it’d be a bullish case for the entire American oil patch. A rising tide lifts all boats – both seaworthy and not. But the reality is much harsher and more severe.

Devastation still ripples through the industry.

And one of the latest victims fell on March 14, when EV Energy Partners (Nasdaq: EVEP) announced it was filing for Chapter 11 bankruptcy.

For months, the company had been trying to maintain its listing requirements for Nasdaq. But the grace periods were of no avail.

It joins the likes of Magnum Hunter, Quicksilver Resources, Ultra Petroleum, and other oil and gas industry darlings from a handful of years ago… a time when the sky was the limit and predictions were for oil to soar ever higher.

In August 2014, when the price of crude was more than $102 per barrel, shares of EV Energy traded for more than $41.

But by February 2016, when crude fell to $26, shares had fallen 95.6% to $1.86.

And even though crude has rebounded more than 100% over the past two years, it was no help to EV Energy… Its acreage was weighted toward natural gas and natural gas liquids (NGLs).

Shares continued to slide.

In its last quarterly report, EV Energy’s output fell 14%, and it was operating at a loss. The Texas-based company’s product mix was 45% NGLs, 29% oil and 26% natural gas.

Even though the prices for all three increased year over year, it simply wasn’t enough.

But EV Energy isn’t alone.

Since 2014, at least 134 North American oil and gas companies have declared bankruptcy.

From January 2015 through the third quarter of 2017, more than $78 billion in debt was brought to court… though only a dozen companies have filed for liquidation.

And the pace has slowed considerably. In 2016, U.S. and Canadian companies sought to restructure more than $58 billion in debt. In 2017, this fell to just $9 billion.

But what EV Energy shows is that there are still dangers lurking in the American oil patch, even though crude itself has performed quite well.

When the oil boom started in 2010, companies took on more than $200 billion in debt to fuel future growth. It was a sensible approach, as crude prices were expected to remain elevated.

So the No. 1 warning sign for energy investors is debt.

A company to avoid at all costs is one that has high debt and negative earnings.

For example, EV Energy’s total debt is roughly $600 million with a debt-to-equity ratio of 89.3. That’s cringeworthy. To throw more fuel on the fire, it’s running at a loss.

Investors could see where shares were likely heading.

There are a few simple rules of thumb to follow when looking at lagging crude oil stocks and whether a rebound is in store.

Investors should avoid companies that have:

  1. A debt-to-equity ratio above 100
  2. Negative earnings
  3. An EBITDA-to-debt ratio above 4… assuming the company has earnings.

Investors can look at these things to protect themselves from potentially dangerous companies… and to avoid further ripples of potential bankruptcies, particularly if the price of crude stumbles.

A rising tide can be a windfall for a troubled company. But if shares of a company are moored at the dock – or sinking – while all its peers are bobbing higher, investors must take a second look. There might be a burden too heavy for it to set sail… and the impending catastrophe could take your portfolio with it.

Good investing,

Matthew