Many of you may have seen that Whiting Petroleum recently announced its bankruptcy, which is significant news to me that I consider worthy of a quick case study.
For those of you who are unfamiliar, Whiting Petroleum is one of the largest Exploration & Production (E&P) corporations in the oil sector (ConocoPhillips is the largest). E&P companies, often called “upstream oil producers”, do exactly what comes to mind when you picture oil being driven from the ground. Other sectors of the “oil economy” are midstream, which involves the transportation, storage, and marketing of oil, as well as downstream, which involves the conversion of oil-products into gasoline and jet fuel.
When the price of rises or falls, it is E&P companies that are the primary beneficiaries or adversely affected entities because they are selling the oil that they produce (whereas the midstream and downstream participants are much more reliant on the total volume of oil that they process rather than whatever the prevailing price may be).
In order for a company to be successful over the long-term in the Exploration & Production sector of the oil company, it must be rational during the bounty years of high profits so that it can avoid the bust years.
Once you are dealing with tens of thousands of barrels of oil per day, you are the type of business that can either make half-a-billion dollars in a year or lose it depending upon the price. In Whiting Petroleum’s case, that was certainly true. It was earning $300-$400 million in annual profits as recently as 2011-2013 and the price of the stock rose to a high of $371 per share in 2014 against 41 million in shares for a total valuation of $15 billion.
What did Whiting do when it was earning $400 million in annual profits in 2011-2013? Whiting management borrowed $5 billion and purchased what amounted to about 300 million barrels of oil equivalent in the Bakken and Three Forks region of North Dakota.
In 2014, oil was priced at $90 per barrel. The management team was probably imagining that the 300 million barrels of oil would would produce $27 billion in revenue minus about $10 billion in costs for a total profit of $17 billion over the coming decade (making the $5 billion in debt worth it).
The problem with this type of risk is that oil, which is notoriously volatile, can not enter a depressed price funk for any period of time because the clock on the debt is ticking while the sole source of revenues is based upon the price of a commodity that you cannot control (and is in fact largely shaped by foreign actors subject to volatile changes in production).
Those 300 million barrels of oil (which make up the majority of Whiting 520 million barrels of reserves) are now only valued at $20 each. Considering it would cost about $27.52 just to extract the oil, Whiting’s proven reserves are worth $10 billion but would cost $14 billion to extract at today’s rates.
Compounding this issue is the fact that Whiting Petroleum only had $13 million in cash in the bank and has approximately $1 billion due in debt over the next twelve months, another $1 billion due the year after that, and another $1 billion due in the three years after that.
For those reasons, it did not surprise many to see that Whiting Petroleum headed to bankruptcy. My own view is that pure-play E&P companies are not suitable for investors who want to own assets on any type of long-term horizon. From 1956 through 2003, the E&P sector produced annual returns of 4.1% while the integrated oil supermajors produced 12.3% annual returns. In other words, E&P companies took on additional risks, put their shareholders through extreme and justified volatility in the price of the stock, and then dramatically underperformed its supermajor peers and barely outperformed inflation over that period. Heck, U.S. Treasuries yielded 4.3% over the same time frame, so you would have actually been better off using the world’s benchmark of a “risk-free investment” than investing in E&P stocks.
And I don’t think the future for E&P stocks is going to get any better. For boom-and-bust cyclical businesses, financial discipline is a requirement to avoiding bankruptcy. Good management has to stockpile the profits in the good times to survive the bad. The problem is that the existence of corporate raiders and management incentive performance plans that reward earnings per share growth (fueled by share repurchases) strongly disincentives the conservatism necessary to run an E&P company in a manner that would lead to outsized returns–or, heck, even in a manner that would avoid bankruptcy.
Personally, I think it is embarrassing that a corporation that earned $1.2 billion during a consecutive three-year period this past decade is now bankrupt with its stock trading at $0.30 per share. But when you realize that bad times are inherent in the E&P sector, and that all of the financial conservatism has been wrung out of the management culture, it is no surprise that bankruptcy is an almost guaranteed occurrence over long periods of time.
Still, people continue to speculate with this stock. Even though it is bankrupt, the shares of Whiting Petroleum continue to trade at over $0.30 per share. This is folly. The point of bankruptcy is to wipe out equity holders, replace them with creditors, and discharge certain debt, beginning with the unsecured debt and then prioritizing the secured debt that is backed by collateral.
Since 2010, there have only been four bankruptcies in corporate America in which the shareholder base at the time of bankruptcy did not get wiped out. This is because each and every creditor has to be fully satisfied before a common equity shareholder is allowed to have any stake in the reorganized business. The only time that is not the case occurs when a substantial secured creditor is also a common equity holder, and usually in those cases, the bankruptcy plan approved by the judge will have some type of provision for the equity holders to enjoy 1-5% of the reorganized company. But that is a rarity where a secured creditor is just trying to negotiate a deal with the other creditors, and in trying to protect its equity investment, provides some third-party unintended benefits to the rest of the stockholder base.
But that is not part of the arrangement at Whiting Petroleum. There is no major secured creditor that is also a meaningful shareholder. Therefore, there is no debtholder with an interest in trying to negotiate any type of ownership stake for the current shareholders when the company reorganizes with the current debt-holders becoming the new shareholders.
People see the stock trading at $0.30 per share, or somewhere in the penny range, and think it might be an interesting speculation. It’s not. It is a function of the bankruptcy courts to satisfy the creditors as much as possible, and there is no creditor who is going to voluntarily surrender some portion of its debt so that the common stakeholders have some type of interest in the reorganized entity. The same company that took shareholders from $371 to $0.30 will now take the shareholders from $0.30 to $0.