A couple of weeks ago when I wrote a post about my bullish leanings on crude oil, I received a whole bunch of feedback warning me about the dire straights of the energy industry. Many were concerned I did not understand the true extent of the damage done to the energy sector.
In actuality, one of my main reasons for my crude oil bullishness is that I do understand how terrible things are in the oil patch. In the coming months, I am anticipating many energy companies going out of business. This destruction of supply is one of main reasons for my forecast of higher prices.
I am decidedly in Blackrock’s Larry Fink’s camp (from a Bloomberg article last week);
Laurence D. Fink, chairman of BlackRock Inc., the world’s largest money manager, said as many as 400 energy companies may not survive because oil prices are not high enough for them to meet their debt obligations.
But how did we get here?
A half dozen years ago, there was a perfect confluence of revolutionary fracking technology along with a desperate desire from investors to pick up yield in a new QE ZIRP environment. These new shale energy companies needed capital to fund their ambitious projects, and the money flowed in at an astonishing rate. But like everything Wall Street touches, a good idea was taken way too far, and too many poor projects were financed. These projects faced high depletion rates and needed cheap cost of capital to be economical. When the price of oil collapsed, the energy bubble burst, and these companies ran into serious trouble.
Now we are left with the aftermath of the bubble - too much supply being pumped from companies with far too much debt. For most of these companies, there is no chance they will make it. The real owners are the bond holders who will be forced to become the next equity investors.
Even if we get a crude oil rally to $35, $40 or even $50, most of these companies will still not be able to survive. By the end of the bubble, most of their debt was issued at levels that required $80 oil, continued access to cheap capital and depletion rates that were probably overly optimistic.
When I say I am bullish on energy, I mean the actual price of crude oil - not energy companies’ equity prices. We have experienced a great bubble, and when a bubble of this sort bursts, it takes a long time to work off the excesses.
Think back to one of the greatest bubbles of all time - the DotCom bubble. When it collapsed many investors were anticipating a big bounce to retrace a significant portion of the decline.
However instead of bouncing hard after the monster decline, the Nasdaq 100 went sideways for the next five years. It was a complete grind as the wheat was separated from the chaff.
It will be no different in the energy equity square. There will not be a return to the glory days of $100 oil when the money flowed freely.
With the relentless bear market of the past year, many of these energy companies’ equity prices are severely depressed. They should be. In many cases the equity is worthless and the bondholders are running the show. Energy equity prices face many years of reorganization and consolidation.
For the price of oil to rally, we need these companies to go out of business. The longer they stay alive, the more the price of crude oil drips lower. When I say I am bullish on energy prices, it is only because I believe the banks and bondholders are about to turn the lights out at many of these over leveraged oil companies.
If you are going to buy oil equities, buy the best of breed company with no (or little) debt. They aren’t cheap, but they should be around in the coming years to pick off some inexpensive assets as the liquidation accelerates. Stay away from down and out garbage stocks. Too many investors are trying to buy the cheapest oil company out there, hoping for a bounce in the oil price to skate them onside. That’s a mug’s game as the final move for these companies is clear. They aren’t going to make it. If you want to speculate on these names, buy the debt. After all, that is the real equity now…
Thanks for reading,