I’m working on several beaten down energy stocks this week and won’t have time to post. That said, I thought I’d put together a quick checklist of some of the things I’m looking for in potential energy investments.
- Companies that took advantage of the recent rally (generosity of dip buyers) and issued equity above net asset values. In several instances, energy stocks are trading well below the prices of 2016-2017 equity offerings. If an energy business was able to improve its balance sheet or buy distressed assets with equity proceeds, its net asset valuation may deserve a boost (due to lower financial risk and issuing equity above intrinsic value).
- Companies that extended their debt maturities/maturity wall. I continue to be amazed by the level of generosity in the credit market, especially given how close many energy companies came to bankruptcy. Specifically, I’m looking for companies that successfully extended maturities to 2022-2025 and with untapped credit lines. Several debt and equity offerings were used to pay down credit lines, which allowed many banks to dodge the energy credit bust bullet. I’ll most likely avoid companies that were unable to refinance debt over the past 1-2 years on favorable terms – it’s a red flag.
- Companies that hedged a significant portion of 2017 and 2018 production at favorable prices. During sector troughs it’s about surviving, not thriving. Cash flow insurance helps.
- Companies with net debt to discretionary cash flow of 3x or less (using current commodity prices).
- Avoid energy stocks that could double or go bankrupt within a year. I call this coin flip investing. Energy companies that I consider coin flips are often reliant on near-term commodity prices for survival. I only want to consider energy companies that can survive an extended period of depressed commodity prices. On a side note, while coin flip investments are not appropriate for long-only absolute return investors, they may be an interesting speculation for certain option strategies (simultaneously buying puts and calls).
- Companies that can survive by drilling within cash flow. In other words, companies that are not reliant on fickle bankers or the bond market and can pay their bills with operating cash flow.
- Avoid valuing energy companies on cash flow. In my opinion, this creates too high of a valuation during booms and too low of a valuation during busts – it encourages buying high and “freezing” when prices are attractive. I prefer a net asset valuation based on replacement costs as I believe it’s a less volatile and more accurate valuation methodology.
- Avoid finding comfort in large discounts to net asset values without sufficient liquidity. It doesn’t matter if the business is selling at a significant discount to net assets if the business doesn’t have the necessary liquidity to survive. Tidewater’s (TDW) recent announcement to enter Chapter 11 is a good example. As of 3/31/17 Tidewater’s book value was $35/share and its stock is currently trading at 80 cents. I wrote about energy stocks and Tidewater in the following post: You Got Your Chocolate in My Peanut Butter
- Avoid extrapolating. Energy stocks are often either significantly undervalued or overvalued – rarely do they trade near fair value for long. In my opinion, these are not buy and hold investments and an area where active management can add considerable value. Take risk when getting paid during the busts and avoid the temptations of holding throughout the booms (For what it’s worth, I’ve found selling in the booms is often harder than buying during the busts – greed can be so powerful!). A rule of thumb I’ve often used is be cautious when commodity prices are 2x the costs of replacing reserves and production (additional supply and the next bust is usually on the way).
- The bottom in energy prices and energy stocks is almost impossible to predict. Be prepared to suffer large unrealized losses as you wait for the cycle to run its course. Low prices and tightening credit should ultimately reduce supply, leaving survivors with strong balance sheets in a favorable position. Lastly, if you miss the bottom, do not worry, the energy industry is home of second chances! Given the energy industry’s obsession with production growth and the financial industry’s obsession with funding that growth, higher supply and the next bust is usually right around the corner.
In conclusion, I’m currently looking for energy companies trading at a discount to my net asset valuation with strong enough balance sheets to make it through the cycle. Given most energy company balance sheets continue to have too much debt, I plan to be very selective and do not expect many energy companies will pass my checklist. That said, I’m hopeful the current mini-bust gathers momentum and provides absolute return investors with an improved opportunity set. Although sector bear markets are often very narrow, they can also be very rewarding. Happy hunting!