The 2008 economic crisis brought the world to its knees. Some 6 to 8 years later, another crisis of sorts in our midst – an unprecedented fall in the price of oil to drastically low levels of around $20. On the surface of it, not much going on there. Looking deeper though, we see a loss of amounting to close to a trillion dollars. Don’t take our word for it though!

Global upstream capital spend from 2015 out to 2020 has been reduced by 22% or US$740 billion. When we include cuts to conventional exploration investment, the figure increases to just over US$1 trillion. The impact of the drop in oil prices on global upstream development spend has been enormous. Companies have responded to the fall by deferring or cancelling projects.

`Wood Mackenzie

Not too long ago, in a report by Haynes and Boone, it was found that 90 companies, which were directly or indirectly affected by the price of oil have filed for bankruptcy in an approximately 1.5 year period. These companies, as it is reported, carry a total debt burden of approximately US$66.5 billion.

And one of those companies is Samson Resources as reported by oilprice.com, a site dedicated to the reporting of energy news. Samson resources had accumulated a debt burden of US$4.2 billion. Even the folks at KKR, a private equity firm specialising in leveraged buyouts got it wrong when they bough the company in 2011. Amidst declining oil prices, Samson could not service the interest and debt payments.

Yes. Private equity folks get it very wrong sometimes. This is not the first and will not be the last of all mistakes made by aggressive private equity players. When a private equity player buys a company, it usually issues debt to finance the buyout. The financing of the buyout is backed in part by the target company’s projected cashflow numbers, such as EBITDA and EBIT and free cash flow and the target company’s assets. If these numbers are affected by the general direction of the macro economy, these deals may go very wrong. For Samson, with $400 million in negative cash flow, how are they going to service the debt? Perhaps the folks at KKR were too optimistic at the time of the deal in 2011. Also, during the period of 2006 to 2011, oil prices were considered “historically high”? This is a chart representing oil prices.

Negative black swans do occurs and we could perhaps take a lesson on this in our own lives. In this case, a fall in oil prices. I have more to say on this but I shall reserve that for another opportune time.

In a report in September 2016, it is also reported that a further 135 companies will go under. This is to be expected of companies which operate in a commodity like industry whose nature is high capital expenditures and debt burdens. The nature of the industry is this:  It drills, finds an asset, borrows against that asset, drill some more, find more assets and borrow against those assets again. Eventually, the debt burdens are too much to bear!

But is this all gloom and doom for value investors. Currently oil prices are slated to recover to $55 levels. It will take some time for capital expenditures to rise again, and then, a little more time for cash flows to be positive. Without a doubt, we will see more bankruptcies being filed.  But in the end, what have we? The survivors! The companies which operated at an optimal capital structure will survive while those with heavy debt burdens perish.  By way of example, Exxon Mobil only has a debt to equity of approximately 27%.  So the survivors will survive. It will be another era again for oil and gas stocks or those sectors supporting it.

Just the other day, I was looking at a company called Thalassa Holdings. This is a company listed on AIM in the UK. By all definitions, this is what many would consider a penny stock, trading at under 50 pence.  Then, it had a market cap of 9.5 mill pounds, zero debt and a price to book ratio of 0.45. It had 0 debt and 13 million pounds in cash. Earnings wise, the company was not at all impressive.  There are many criticisms of the company and its chairman but I believe that the company will be one of those survivors that I was speaking of.

Closer to home, Singapore! Sembcorp Industries, a conglomerate whose business is utilities, marine and more also slid due to the fall in oil prices. When I was looking at this company, it only had a market capitalization of $4.5 billion. Earlier on in this article, I spoke about KKR. I would say to KKR, if you had wanted to do a buyout, maybe now is a better time to do so if you can get credit and you are invited to take a look at Sembcorp Industries! If we slap a PE of 10 times on 650 million in approximate net income going forward, the company should at the very least trade at a market capitalization of $6.5 billion in the long run. I think this to be conservative for a large and currently unpopular company. This company could well trade higher. 2014 net income was $454 million. With regards to the $650 million of estimated net income going forward,  I wouldn’t use this valuable real estate to justify that figure in this article. In another article perhaps?  For those of you who bought this company at $2.60, well done, the price currently stands at $3.12. But don’t be too gleeful. The market is one crazy animal I assure you. Your feelings about it will not influence it!

With all that rambling, I hope investors get the message. Not all is gloom and doom unless you are Marc Faber or a believer in the efficient markets hypothesis. There are always pockets of opportunity awaiting contrarians and conservative value investors. The question is whether investors are able to step back, think and act rationally.  Not all the time I suppose. If not, all of us would be millionaires by now. It really takes a rewiring of the brain to look at things from a different angle. After millions of years of evolution, the fight or flight syndrome, the herd mentality and social proof biases permeate our psyche.  Value investors strive to fight these biases within themselves. After all, can I say, we are our own worse enemies!

 

Categories: Issues On Debt

kingsley

I have been an investor for 15 years now and my journey has meandered from Warren Buffett to Ben Graham. My start, like many, really was the naive idea that Buffett's skills could be replicated in some fashion. I was proven wrong when some of the supposed stock picks that I chose had dismal performances. Then, I learnt that it is no point trying to be someone I am not. Gradually, through failure and some success in deep value investing, my approach towards stocks gradually shifted to an approach based around Graham's techniques. So, I give credit where credit is due and to Ben Graham, I and many other investors around the world, owe him a great deal. So, if you want to read up on biographies, read about Ben Graham. His seminal work, Security Analysis is a gem. My books are just rich interpretations of what he has taught.

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