The recent rally in crude (crude is up by more than 70% since its February 2016 lows) has reinvigorated interest in energy stocks and given a forlorn energy patch renewed hope. Nonetheless, despite growing consensus that the bottom is now in for crude, investors should still treat energy stocks with a degree of caution because the storm is far from over.
Now what?
There are signs that the oil rally may shortly run out of steam. A number of fundamental indicators highlight that it may be some time before crude reaches the prices required to make many of the “zombie” companies operating in the North American energy patch viable once again. These companies continue to shuffle along under the weight of mountains of debt, despite deteriorating financial positions and weak oil prices.
Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) has warned in its first-quarter 2016 results that it may not survive. It is on the verge of breaching its financial covenants and, even worse, its oil output continues to decline as it is unable to find the cash to invest in exploration and development.
Then there was the collapse of Colombia’s largest independent oil producer Pacific Exploration and Production Corp. (TSX:PRE). It entered the oil bust a whopping $5 billion in debt, and when coupled with its high operating costs, its financial condition deteriorated as the price of crude fell. It recently filed for bankruptcy protection in Canada and Colombia and is the subject of a capital restructuring that will wipe out any value held by shareholders.
Clearly, investors need to use caution when investing in the energy patch.
Even names such as Baytex Energy Corp. (TSX:BTE)(NYSE:BTE), which is being touted by analysts as one of the best levered plays on crude, remains under considerable pressure.
You see, Baytex loaded up on debt at the height of the oil boom as it beefed up its operations through acquisitions. This debt now totals over $2 billion and comes to a staggering four times cash flow, highlighting just how precarious the company’s position is. Nevertheless, unlike Penn West, there are no signs of it breaching its financial covenants.
Another problem Baytex is facing is that in the current harsh operating environment, it doesn’t have enough cash to spare to invest in exploration and growing production. This means that its current capital expenditures and investments in its operations won’t even offset those reserves lost through natural decline rates.
Accordingly, its 2016 oil production will fall by at least 15% compared with 2015, meaning it won’t be able to take full advantage of higher crude and will see a decline in cash flows, creating even greater financial pressure.
So what?
The outlook for Baytex is nowhere near as bleak as Penn West’s; the biggest issue they are both facing is that they are weighed down by mountains of debt. This is forcing them to slash spending as they try to generate as much cash flow as possible, so they can meet their financial commitments and whittle down their debt to ensure they don’t breach their financial covenants.
As a result, they are unable to invest in replacing depleted assets, meaning that if they emerge from the current crisis, they will be in a far weaker position than when it commenced.
