Oil Re-Bloodies the “Smart Money”

The “liquidity death spiral.”

Oil plunged again on Monday, with West Texas Intermediate down over 4%. At $45.17 a barrel, it’s just a hair away from this year’s oil-bust low. During 8 weeks in a row of relentless declines, WTI had plunged 26%. July’s 21% drop was the largest monthly decline since the Financial Crisis collapse in 2008.

There’s a laundry list of perceived reasons: The rig count has been rising again. Shale oil companies, like Whiting Petroleum, are bragging about “record” production to prop up their shares. Production in Russia has been strong. And OPEC, powered by Saudi Arabia and increasingly Iraq, raised production in July to 32 million barrels per day.

There’s the dreaded surge of Iranian oil onto the world markets. Just this weekend, Iran’s oil minister mused that his country could raise oil production by 500,000 bpd within a week of when the sanctions would be lifted and by 1 million bpd within a month.

It gave oil markets the willies. They were already fretting over the slowdown in China, the crude oil inventories in the US, at a record for this time of the year, the oil inventories in other developed markets, and even oil stored in leased tankers. Oil everywhere, it seems.

Whatever the perceived reasons, the price of oil has gotten re-crushed, and so has the hope a few months ago that this would be over by now.

Moody’s is ringing alarm bells over a wave of defaults among US oil and gas companies: “The energy price slide continues to create operating and liquidity pressures for the oil and gas sector, which contributed to seven of the 15 defaults recorded and accounts for a large share of companies with low ratings and weak liquidity.” And it expected the energy sector “to be a primary driver of defaults over the next year.”

Banks are going to reassess their energy loans this October, a twice-a-year ritual. These loans are backed by oil and gas reserves. When prices plunge, the value of the collateral plunges in parallel. Banks, under increasing pressure from regulators to get a handle on this, are going to slash these credit lines. And even more liquidity will drain out of the sector.

This coincides with the expiration of the hedges that have protected so far a portion of these companies’ revenues, but won’t do so going forward.

“Liquidity death spiral,” is what S&P Capital IQ called this phenomenon.

Linn Energy LLC saw its shares (units, actually) plunge 50% over the last three trading days, including 19% on Monday, to $3.28, down 90% from their 52-week high last September, following revelations on Thursday of a big fat net loss of $379 million in the quarter, as revenues had plunged 46%. To stay liquid a while longer, Linn said it would eliminate its monthly income distribution (similar to dividends). But at least it hasn’t defaulted on its debt yet, and its bonds, which had been brutalized, actually rose after the announcement.

The thing is, early this year, as oil dropped below $50 a barrel and as oil-and-gas lenders were licking their wounds, smaller oil-and-gas companies where wheezing for liquidity. Then the smart money piled into the market with offers they couldn’t refuse.

At the time, major private equity firms and bond funds that had already pocketed big losses in the sector – among them Carlyle Group, Apollo Global Management, Blackstone Group, KKR, and Franklin Resources – were throwing more money at these companies, often their own portfolio companies. But the PE firms structured their deals to give them preferential treatment so that during a restructuring they could get their hands on some of the prime assets.

And the new money bailed out their prior investments, at least for the moment. Energy companies issued about 15% of all junk bonds since 2009. Now these bonds make up an uncomfortably large portion of these funds, and the pressure is enormous to salvage what can be salvaged by throwing new money at it and hope for a miracle.

Lo and behold, the miracle arrived, and the price of oil soared 30%, and those investments looked prescient – until now. The Wall Street Journal:

Funds managed by Franklin Resources Inc., Blackstone Group LP, and Oaktree Capital Group LLC, among others, are facing paper losses on substantial investments this year in exploration-and-production companies.

Many of the investments amounted to a doubling down on existing stakes, as the firms committed hundreds of millions of dollars to lend to or invest in energy companies whose debt they already held. Among those gaining access to much needed cash: Warren Resources Inc., Goodrich Petroleum Co., and Energy XXI Ltd.

The largest among these deals was Energy XXI’s $1.45 billion offering in March of 11% secured bonds due in 2020. To pull off the deal, XXI approached its existing bondholders, including Franklin and Oaktree, and they agreed to buy about half of these bonds at issuance.

Since then, these secured bonds have lost about 25%, but the unsecured bonds lost 50% and are in the process of being annihilated: On Monday, the secured bonds they were trading at 73 cents on the dollar. The unsecured 9.25% bonds due in 2017 were trading at 36 cents, down from 75 cents in March just before the deal.

But hope remains. “In some instances, we expect the process to be lengthy and may result in reorganizations, but that doesn’t mean that our returns won’t be attractive,” Ed Perks, portfolio manager of Franklin Income Fund, told the Wall Street Journal.

Unsecured bondholders suffered similar or worse losses in the other deals, with new money getting whacked as well, though somewhat less brutally, as energy junk bonds have become toxic.

Not all companies were this lucky. Some missed the window of opportunity. As the riskiest end of the junk-bond spectrum was swooning, some of these deals had to be pulled, including the $640 million loan offering in July by Swift Energy. Now the company has hired Lazard to help rejigger its capital structure, a signal to creditors that bankruptcy is now a real threat. And that, as Moody’s warned, is going to be a bigger theme.

The oil bust has had a peculiar effect on Canada, and at first, there was hope that only the oil patch would get hit. Read… It Gets Ugly in Canada

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  16 comments for “Oil Re-Bloodies the “Smart Money”

  1. LG says:

    I was approached years ago by a European “trade” minister to raise six plus figures to train Iranian oil in to Serbia and refine it at five US dollar a barrel. Later on they informed me that money was actually to open a bank so they could write purchase orders for the oil.
    Good ol days.

  2. Uncle_Frank says:

    Now for the industry perspective…

    Top 6 Myths Driving Oil Prices Down

    “Over the last few weeks I have witnessed another litany of lies that the media insists on putting forth. They come in the form of statements presented as facts to sway opinion while others are opinions quoted by others. Either way, the bias in talking down oil prices, reinforcing the ‘glut’ that is fueled in part by misleading EIA and IEA data, is readily apparent.”


    • Wolf Richter says:

      The “industry” sounds very silly, ridiculous even, by blaming the media for the oil price plunge. And btw it didn’t blame the media when oil was soaring for all these years.

      • Uncle Frank says:

        You are right on the mark Wolf. Here in oil patch land they have to blame someone else for all the layoffs and stock/bond busts.

  3. Petunia says:

    I’m still waiting for my electric bill to drop now that oil is 50% cheaper.

  4. Michael Gorback says:

    I’ve been tracking Linn Energy and the swings have been wild, pretty much reactive to the latest EIA reports and the status of the Iran deal. I think one day it changed 20%. Today it’s up 5.75% so far.

  5. Julian the Apostate says:

    Of course they blame the media, Wolf. It can’t be THEIR fault…but when the price is up they’re BRILLIANT!

  6. michael says:

    Unfortunately the drop in commodity prices will not be passed on to the consumer. The manufacturer or service provider with absorb any and all favorability

  7. Colin says:

    If shale companies start going bankrupt in big numbers, would US oil production be effected much?

  8. merlin says:

    Merlin the magnificient oil maven looked in his crystal ball and saw…….

    looking back
    1. drilled too many wells to keep from losing rigs to competitors
    2. flowed at flush production which is not efficient to drain the reservoir effectively
    3. paid too much for leases

    looking forward
    1. $40 oil 2015, $50 oil winter 2016 then back into forties, $50-60 oil in 2017
    2. Drill smarter in the future: fewer but better wells from multiwell locations
    3. recycle of all flowback water will become a law
    4. lost of qualified hands and more regulations will slow the recovery.
    5. all wellsites will require a seismicity survey
    6. You wont see 1800 rigs working onshore US again………
    7. And the refinery needed for US lighter gravity oil will not be built for a variety of political and regulatory reasons.

    hope Merlin is suffering from medical marijuana use……

    • night-train says:

      Merlin: Much to agree with there. But absolutely, positively on the lease prices. The prices I was hearing were staggering. I have been around the oil patch since the late 70’s. The lease prices for goat pasture were as high or higher than fairway acreage in a number of good established conventional plays.

      I do have one issue with the prognostication: ” 2. Drill smarter in the future: fewer but better wells from multiwell locations.” I think they have already been drilling their best locations. I don’t think you will see “fewer better” wells. Simply put, geology trumps technology. Calling most of these rocks “reservoirs” is stretching that concept almost beyond recognition. They are trying to produce source rocks, geologically speaking. Technology will no doubt improve, but so will the corresponding costs of said technology. So in short, the shale players need $100 plus to be profitable.

  9. steinm88299 says:

    Meanwhile gas here in Seattle has been stuck at $3/gallon for weeks. When oil rises they raise the price daily and sometimes even more than once a day. Congress should look into the fact that gas should be much cheaper, but that would require Congress to do something. And can someone please tell me why I should care that oil is so cheap? The CNBC talking heads make it sound like somehow cheap oil is a BAD thing…

  10. Sgt Milstar says:

    Gas here in Southern California just can’t break into the $3.XX level.

  11. loc nguyen says:

    It looks like oil might go up a little thru this summer(light volume trading = lethal MM @ work). Then will go down from there, maybe even reach 10 – 20 WTI. Just like Gary Shilling said the only one thing still hangs on is equities, and it’s next in Fall ’15?

  12. Dyson says:

    Unsecured bondholders suffered similar or worse losses in the other deals, with new money getting whacked as well, though somewhat less brutally, as energy junk bonds have become toxic. Not all companies were this lucky.

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