This post would have been great just a couple of months ago… Although, admittedly, I did get to make a Halloween reference in October anyway.
Earlier this year (for example, here), I began documenting the problems with smaller e&p companies in the region. Even earlier (for example, here) I began to call these companies “zombies” – companies hovering somewhere between life and death, with an unquenchable thirst for cash. I’ve discussed the vicious cycle, wherein these zombies are able to operate some of their existing assets just enough to access debt markets, and then use most of their cash flow to service that debt. Thus, they stay alive for a lot longer than market forces would allow for otherwise.
The real problem with zombies, though, is that they infect everyone around them… Because they have to continue to pump oil to service debt, and they get to continue to obtain debt financing by maintaining cash flow, there is a very real delay in how fast production of crude in the United States will decline, despite arguments to the contrary. (Petrie Partners has earned the ire of The Wolf Camp before, are these guys ever right???) This in turn means that the price stays lower for longer… which means that companies that may have otherwise survived this downturn become, themselves, zombies…. etc.
The Pack welcomes to this discussion Reuters, which has just noticed that there are oilfield companies staggering among the derricks and pumpjacks of West Texas, feeding on whatever debt some poor bank is dumb enough to issue (and the bondholders who take that risk). This article’s first zombie ecxhibit is Magnum Hunter Resources, who was Patient 0 in the current outbreak. At the beginning of this year, they ceased all new exploration and are relying on their existing wells (which are declining in production every month), to keep them alive until the oil price comes back – hopefully in 2017.
Which would be great, if every other highly leveraged company (I’m looking at you SandRidge Energy, you’re starting to twitch) in the industry weren’t trying to to the exact same thing. In short, this is a strategy that works when you’re the only player at the table. Once you’re among a group of “dead money”, though, everyone is just waiting to see who gets the ax first.
“But why should we care?” you ask? Again, it is because of the contagion effect. Zombies are contagious… Don’t you watch movies? These zombies infect companies that otherwise would be perfectly capable of surviving the current crisis… while at the same time lengthening the crisis itself by refusing to die. Zombies are SO annoying that way!
The worst part of this cycle, however, is what the Reuters article quoted someone as calling the “slow-motion liquidation”. What that means is that these companies are actually bankrupt, but not declaring bankruptcy. Why is that a problem? Because, when the rent finally comes due, these companies will have nothing left for a bankruptcy estate, except for these depleted assets… This means that creditors get wiped clean on their investment in these zombies, which spreads the contagion even further.
Honestly, for many of these companies (without naming names), it just seems like reorganizing they’re finished early – you know, while there is still some (pardon the pun) liquidity – is a better outcome in the aggregate. With the current slate of managers, however, to stop this slow decay is to get activist investors to force companies into restructuring before it’s too late… It remains to be seen whether anyone will.