After Friday's spectacular 10% sell off in black gold, I went back to my earlier post on shorting crude oil and felt pretty darn good as I made myself a turkey sandwich for lunch. Some would say it was a capitulation bottom but I just didn't see the volume which would come with such a move. Yes there was heavy selling but it was funds getting OUT of energy names and forced selling - not buying a dip. Sure, it can snap back and a near term bottom is most likely in but I will not be trading that. The top is in in my opinion. I will view any move higher (without an event risk occurring) as an opportunity to re-short at a higher level.
I still believe the entire sector is extremely over crowded with over 100 oil companies just in the U.S. alone. While deflation in any sector is difficult to swallow, I may not be too far from the truth. According to the WSJ:
Energy stocks are on sale following a five-month plunge in crude oil, but so far few investors are heeding the temptation to bargain-hunt. Portfolio managers and analysts are bracing for a wave of dividend cuts, share-repurchase delays and capital-spending reductions that will likely ripple across the industry.
Consider Norwegian offshore driller Seadrill (SDRL) announced just a week ago it will halt it's dividend payments and refiner CVR (CVRR) who only debuted it's IPO in 2013, cut it's dividend by 18% in October and we could be seeing the beginning of a slightly unsettling energy top. No, certainly two dividend cuts does not a top make but consider the five-month drop in crude oil prices and what happened in the past when there was deflation in a sector.
As one of thereformedbroker's readers pointed out:
Energy companies are the 2nd largest issuer of HY debt. With the ongoing massacre in crude oil my thought has been that the highly leveraged players would have debt issues which would just facilitate industry consolidation. But with the state of the credit market excluding sovereigns, we could have something else entirely. The energy sector makes up a large segment of the HY bond market and it’s about to take a big hit.. Sooner or later it’s coming. If the high-yield market in it’s fragile state is given a push we could see a real route in the markets. It’s starting to look like energy debt could go bidless for a time and take HY with it if action isn’t taken soon. And that action, in part should be for the orgy of debt issuance that is being used for buy-backs to stop asap.
So what do buybacks do for the stock market? Push prices higher. What happens when a buyback program or a dividend is cut? Prices fall as dividend funds get out of their positions. They are, after all, THERE for the yield.
Last let us consider their debt vs. increased costs. According to TheGuardian:
The US Energy Information Administration (EIA) said a review of 127 companies across the globe found that they had increased net debt by $106bn in the year to March, in order to cover the surging costs of machinery and exploration, while still paying generous dividends at the same time. They also sold off a net $73bn of assets.
This is a major departure from historical trends. Such a shortfall typically happens only in or just after recessions. For it to occur five years into an economic expansion points to a deep structural malaise.
The EIA said the shortfall between cash earnings from operations and expenditure -- mostly CAPEX and dividends -- has widened from $18bn in 2010 to $110bn during the past three years. Companies appear to have been borrowing heavily both to keep dividends steady and to buy back their own shares, spending an average of $39bn on repurchases since 2011.
Right now there's a price war going on in crude oil with OPEC unwilling to cut production (lest they risk losing customers to the U.S. or Russia). The worldwide glut of excess supply will continue to weigh on price and operational costs. This drop will definitely weigh on economies who depend heavily on crude oil for GDP growth such as the Middle East, Venezuela and Russia. Oddly enough India's economy stands to lose the least as they import over 80% of their energy needs.
With no driver to push crude higher, what will oil and gas companies have to do to offset the lower price of oil? Cut costs - big time. Certainly the stronger names will be able to survive longer than the smaller, heavily indebted ones but we're already seen five months of price decline. If I were the CFO of an energy company, I would already have been exploring the ways to survive. Renegotiate with suppliers, equipment manufacturers, drillers, and railroads who haul it (so watch them all to be pressured as well as the dominos fall). Let's assume they have already refinanced their debt prior to the credit crisis. Now we may see more selling of non-performing assets, restructuring and cost cutting..........and yes, cuts in buybacks and dividends. It won't be pretty. Just ask the airlines how it felt after they went through airfare wars and cost cutting measures. Many didn't survive. Others were merged with large players; thus shrinking the number of competitors. Years of pain.........but once the smoke cleared, they are now lean and mean EPS generators.
Hold on to your hats in you're in the energy sector. It's going to be a bumpy ride.
(Edited 10:40am to add EIA data)
Comments
Another great way to influence longs in crude oil: increase margin requirements. I'm sure this wasn't leaked ahead of time (wink wink)