Monday, September 14, 2015

"As Oil Prices Decline Watch These Balance Sheets"

As I footnoted in a 2010 post and ref'd in 2011's "Climateer Line of the Day: Voyeur Edition":
...One of my mentors could not stand indecisive traders. He loathed them almost as much as he loathed losses. 
If one said about an instrument "I'm watching it" he'd bellow "You like to watch? What are you, a freaking voyeur?" Except he didn't say "freaking". 
If you were asked about implementing a certain strategy and said "I'm thinking about it"  the response was "What are you, a freaking philosopher?", again substituting a different word. 
Remember that the next time somebody tells you they have something they want you to watch.

From Thompson Reuters' AlphaNow:
A few years ago – in the days of high oil prices — energy companies spent record amounts on capital expenditures and significantly increased production, looking toward future earnings. That meant increased debt loads and poor cash flows, waiting for those earnings to materialize. Now factor in the sharp drop in the price of oil — by nearly 50% in the last year — and those projects may not be as profitable as planned. 
While managing their balance sheets, companies in the energy sector have been through turbulent times, and the high-yield sector spreads show that investors may be most nervous about this sector. As you can see in the chart below, the yield for the energy sector was 9.9% (this the premium over the risk free rate), significantly higher than any of the other sectors. That means that reaching to the bond markets to raise money to finance new projects has a high cost for energy companies.
Graph 1
Source : Datastream/ Bank of America Merrill Lynch Master Index
Even more concernsBesides lower oil prices, there are other reasons to be worried about companies in this sector. We took a look at companies in energy sector headquartered in the Americas with market cap of more than $10 billion. We compared the capital expenditures over the past year to depreciation. When capital expenditures exceed depreciation, the company is increasing its asset base, and is probably investing in new equipment to increase production. What we found is that more than 90% of the energy companies (45 out of 48) are spending more this year on capital expenditures  than they depreciated last year. Despite the fall in oil prices, companies continued to spend to increase their capital base. With poor or negative free cash flows, the funding for that likely comes from an increase in debt levels. We took a look at long term debt compared to two years ago. 
Here we noticed that of the 48 companies that passed our screens, 37 had more long term debt on their balance sheet than they did two years ago. More than half the companies (26 out of 48) have seen long term debt increase by more than 20% in the past two years. Considering that more than 31 of the companies have a Credit Combined Score of less than 30 (which puts them in junk bond category according to our StarMine Credit Combined Risk Implied Rating) tells us that a lot of energy companies are taking on additional debt at very high interest rates, and falling oil prices and revenues are likely to hurt earnings going forward. It also probably increased the likelihood of default for many companies, or we may see an spike in M&A activity as companies with stronger balance sheets take over those with weak balance sheets in the hope that oil prices rise in the future. 
The StarMine Credit Combined Risk Implied Rating is a quantitatively calculated rating based on the Credit Combined Risk Model. This is not an agency rating, and most of the Implied Credit ratings are below the agency ratings. However, historically when the agencies have changed their ratings, they have been 4-5 times more likely to move their ratings towards the Implied Ratings than against it.
Risks in capital spendingWe took a look at the companies with the largest capital expenditures compared to depreciation. These companies are investing heavily over the last year, a bad time to increase capital spending. Of these, we looked at those with the poorest Credit Combined Scores. The table below represents these companies....MORE
Previously in the Shopping for Shorts series:
January 7, 2015
Oil: "The First Shale Casualty: WBH Energy Files For Bankruptcy; Many More Coming" (the most leveraged energy companies)
January 8, 2015
Citigroup Goes All Medieval On the Energy Sector, Takes Quarterstave and Broadsword to Estimates
April 2, 2015
"These Shale Companies Will File For Bankruptcy First: Goldman's "Best And Worst" Shale Matrix".