2 Key Lessons From the Pacific Exploration and Production Corp. Train Wreck

The debt restructuring of Pacific Exploration and Production Corp. (TSX:PRE) highlights just what can go wrong with heavily leveraged oil companies, illustrating important lessons for investors.

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Beaten-down Colombian oil producer Pacific Exploration and Production Corp. (TSX:PRE), which was on the verge of bankruptcy, has restructured its debt through a deal with Canadian private equity firm Catalyst Capital Group Inc. This deal, which reduces its debt by about US$5 billion, was a costly affair for shareholders; it virtually wiped out their equity upon completion.

Regardless of the deal, Pacific Exploration has now filed for creditor protection, highlighting just how precarious the company’s position is.

The trials and tribulations of Pacific Exploration are a stark reminder of just how wrong things can go when a company loads up on debt and makes questionable acquisitions, highlighting two key lessons for investors.

Now what?

The roots of the harrowing saga can be traced back to 2013 and the height of the oil boom when Pacific Exploration–then known as Pacific Rubiales–was the darling of the Colombian oil patch. Not only had it successfully navigated the intricacies of operating in Colombia to become that country’s largest independent oil producer, but it had amassed a sizable portfolio of high-quality exploration assets.

Then management made the fateful decision to acquire fellow Canadian-listed, Colombian oil company Petrominerales Ltd. for $935 million and assume its $640 million in debt.

This was the largest of over 10 acquisitions made by Pacific Exploration as it sought to maintain its aggressive growth profile, which allowed net production grow at a very impressive compound annual rate of 59% since 2007. In order to finance the deal, Pacific Exploration took a $1.3 billion bank loan, which saw its debt grow to over US$4 billion when combined with the debt assumed from Petrominerales.

By the end of 2015, that debt had ballooned to an unmanageable US$5 billion. When coupled with the sustained slump in crude, the company was unable to meet its financial obligations. It was forced to defer a US$66 million interest payment on its senior notes in January of this year.

This emphasizes that those companies which focus solely on growing aggressively through debt-funded acquisitions are high-risk investments that are highly vulnerable to any downturn in the economic cycle.

A similar outcome can be seen with Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE). Like Pacific Exploration, it loaded up on debt and went on a massive spending spree, acquiring assets of questionable quality that left it vulnerable to the slump in crude. As a result, it now it finds itself in dire straits and could potentially face a debt restructuring.

Then you have Pacific Exploration’s failure to retain its interest in the Rubiales field; it is set to return to Colombian government-controlled Ecopetrol SA in mid-2016.

This was contrary to claims from management that it would be able to successfully negotiate a new contract to retain its interest in the field. Subsequently, Pacific Exploration will lose over half of its oil production from mid-2016 and, despite reassurances from management, it has failed to develop any alternative assets to replace that production. This loss will cause Pacific Exploration’s revenue to fall sharply later this year, leaving it unable to meet its financial obligations.

The inaccurate claims of management highlight that it is crucial for investors to conduct their own due diligence or rely on an independent expert to do this for them. This is why a subscription to the services provided by the Motley Fool can be a valuable investment; our independent voice helps to cut through the market noise.

So what?

The demise of a company as promising as Pacific Exploration illustrates what can go wrong with high levels of debt, an aggressive acquisition strategy, and a lack of focus on organic growth. In effect, it leaves them extremely vulnerable to any downturn in the economy or slump in commodity prices.

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 Smith has no position in any stocks mentioned.

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