Debt now key factor in energy
He’s an old-timer, part of the old generation, and his way of doing business is out of style, many analysts say. The new generation is all about financial savoir-faire and big risk.
Some of the Barnett Shale’s biggest operators have debt on the books worth more than many countries’ gross domestic product. Devon Energy Corp. reported in its latest quarterly earnings statement long-term debt of $5.8 billion. XTO Energy Inc. has long-term debt of more than $10.3 billion. Chesapeake Energy Corp. reported long-term debt of $13.568 billion – roughly equal to the 2008 GDP of Albania. The companies use hedging to lock in prices and orchestrate complicated deals with names like “volumetric production payments.”
The modus operandi: load up on debt to fund an aggressive expansion and watch the stock price soar, despite the fact that natural gas hasn’t made significant in-roads into new markets and demand has been flat for some time.
“It is a completely different strategy than the old, tried-and-true ‘stick to your strengths’ and ‘make sure you have a good a balance sheet, don’t hedge’ – that’s out the window,” said Fadel Gheit, managing director of oil and gas research at Oppenheimer & Co. “They’re sophisticated, for better or for worse.
“A lot of companies aren’t run by geologists anymore. They’re run by financial people,” Gheit added. “I’m not saying it’s good or bad. … but they are able to use financial instruments much more efficiently and grow the company at a significantly faster rate than their counterparts: the old lion conservatives. That is, in my view, a paradigm shift.”
Natural gas exploration and production companies were the darlings of the stock market beginning in 2007 and running through the first half of 2008. One company’s share price gained 80 percent in a six-month span. Conservative companies didn’t fare as well as those that took on more debt and more risk.
“That tells you where investor appetite is going,” Gheit said. “Maybe the investment philosophy has changed. People are getting younger, more aggressive and pushing the envelope … As an investor I can say great things about companies that are conservative, but at the end of the day people look at their investments and say, ‘What have you done for me lately?’”
Assessing which companies are taking more risks than others involves looking beyond the balance sheet, said Phil Weiss, an analyst with Argus Research Co. Examine operating leases, hedge prices, reserves and more.
“I don’t look at it in absolute numbers. What kind of credit lines do they have?” Weiss asked. “Some companies are trying to maintain some flexibility. If they have that little cash I’d want to know what other sources of liquidity they might have.”
Also, some companies have debt on the books simply because they could get the credit.
“They basically said, ‘We can get this debt and if market goes down we can have this debt at time when we might not be able to get it,’” he said.
Is that smart?
“It depends on the company,” Weiss said. “My general view is if you’re running your business soundly why take on that debt if you don’t need to. If you have some type of intelligence that regardless of market strength credit will tighten, then maybe that makes sense, but in general why should I increase my expenses or increase my leverage?”
It’s a capital-intensive industry, and the resources sought deplete with each passing day.
At 98 years old, H. Bryan Poff is no stranger to the oil and gas industry’s ups and downs over the decades, but the way that some companies operate these days is without a doubt a one-way ticket to bankruptcy court, he said.
It’s “absolutely” dangerous to take on too much risk in the industry, “especially now since gas has hit the floor more or less,” Poff said. When gas is up no one gets hurt, but if gas prices remain low through this winter damage will be done. Of course, there are similarities between the gas game of yesteryear and that of today.
“Well it’s always been a risky financial game,” said Poff, adding, “Anytime you put a hole in the ground it’s a risk, I don’t care who or where it is.”
The way bankers view the industry has changed, however. Financial people aren’t interested in the long-term prospects for oil and gas, but rather what are the immediate returns on their investment.
“You couldn’t go down to the bank this morning and borrow $20,000 on an oil property. I might borrow $20,000 but it won’t be on a property,” he said. “But I used to walk out of the Fort Worth National Bank with any amount of money.”
The word ‘oil’ implies ‘striking it rich’ to the average person, but nothing could be further from the truth, Poff said. Oil isn’t analogous to wealth.
“But the average person isn’t a trained geologist,” he said. “To the average investor that’s the way they think. That’s what it amounts to … Investors are fascinated by the word ‘oil.’ Oil fascinates anybody, it always has. They think everybody’s going to get rich.”
That immediate gratification is part of what makes the industry so different than the wildcatter days of old, Gheit said.
“More investors are willing to take risks and they’re pushing companies to the limit and companies are willing to oblige,” he said. “It’s very hard to point the finger at who is guilty, we’re all guilty. We created a situation that in my view is not sustainable.”
One problem is hedging, which Gheit said is “totally out of control” and has created companies that should not be in business in the first place. But Gheit understands its appeal. Hedging involves locking in prices for natural gas to better manage the frequent price swings of commodities. If not for hedging, many companies would be posting huge losses.
“They are using something that is available, acceptable, legal – so why not?” Gheit asked. “But I think it’s distorting the industry, in a way, unless this is the new industry. It’s like when everyone wears platform shoes. They all appear to be taller but, in fact, they are not.”
