Will Penn West Petroleum Ltd. Make it Through 2016?

Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) sees trouble as soon as the second quarter.

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These are really dark days for the energy sector. Weak oil prices continue to put pressure on the financial viability of a growing number of oil and gas producers. One company where that’s abundantly apparent is Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE), which is dangerously close to the brink, calling into question the company’s ability to make it through this year without going belly up.

A really tight spot right now

Penn West Petroleum’s finances are very tight right now. That’s pretty clear after the company cut its capex budget by 90% over what it spent last year to a mere $50 million, which is actually not enough money to drill any wells this year. On top of the steep spending cut, the company also suspended its dividend, cut compensation to its board of directors, and slashed its workforce by 40%.

These cuts are necessary because its cash flow has been decimated by weak oil prices. Last quarter, for example, the company only generated $7 million in funds flow, which was 95% less than the fourth quarter of 2014. For the full year, funds flow was a mere $180 million, which is 81% less than the $935 million it generated in 2014.

With oil prices only growing weaker in 2016, the company needs to do something to bolster its sagging funds flow, which is projected to be even lower this year.

The clock is ticking

Because its cash flow has fallen so steeply, Penn West Petroleum has had to work hard over the past couple of years to address its financial problems. Aside from cutting expenses, the other important thing the company has done is sell assets; it unloaded $800 million in assets last year and used that cash to pay down debt. These asset sales have enabled the company to make tangible progress on debt reduction, cutting its debt in half since its peak in late 2012.

PWE debt

Despite all that progress, the company still has too much debt for the current oil price. That’s clear by looking at its leverage ratio, which last quarter was 4.6 times debt-to-EBITDA. That’s dangerously close to the company’s five times covenant limit.

That limit is a growing concern because the company is on pace to exceed it as early as next quarter should oil prices remain weak. Because of that looming deadline, Penn West Petroleum has already started talking with its creditors about their willingness to be flexible with its covenants given the current conditions in the industry.

The concern, however, is that its creditors, which have been lenient in the past, might not be quite so lenient this time given that industry conditions have gone from bad to worse; oil prices are down 50% since the company last sought leniency from its lenders. If they are not lenient this time around, the company might be forced to sell assets at fire-sale prices just to get back into compliance.

Clearly, the company has a lot of work to do. It will likely try to avoid breaching its debt covenants by selling additional non-core assets sooner rather than later. Further, the company is considering the sale of its foreign exchange hedges as an additional source of liquidity; it holds roughly $50 million in positive value from these hedges.

In addition, the company will also consider taking on a strategic investor to provide it with a cash infusion to bolster its balance sheet. In other words, all options are on the table right now to keep the company from going under.

Investor takeaway

Penn West Petroleum is in a really tight spot right now due to very weak oil prices and too much debt. There’s a growing possibility that the company could default on its debt as early as the second quarter if its lenders aren’t lenient. That’s why it’s exploring all other options to avoid breaching its debt covenants, so it can make it through 2016 without having to declare bankruptcy.

Right now, however, it’s really a coin flip as to whether or not the company stays afloat.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Matt DiLallo has no position in any stocks mentioned.

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