Oil Re-Bloodies the “Smart Money”

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.