Although I would much prefer to talk about the fast-developing hot stove moves in Major League Baseball, the Baltimore Ravens playoff chances or recent books I have enjoyed, the subject of oil and oil-related stocks is pretty much inescapable right now.
I have long held a positive long-term opinion on all things related to carbon energy and own several energy-related stocks. And I still hold that view despite the carnage seen in oil prices and oil and oil service stocks. I just do not see alternative energy solutions growing fast enough or carbon energy demand declining over the next several decades. So, I am a carbon energy bull.
I have written about the increasing private equity activity in the energy sector over the past year. I do not think the recent tumble in energy-related assets is going to send the private equity guys running from oil and gas assets. Indeed, in all likelihood, it will have the exact opposite effect.
This morning, I downloaded the Monthly M&A report from Merrill DataSite and found that energy, mining and utilities was the most active M&A and buyout sector in October. A total of f 116 transactions worth $55 billion were completed during the month. I doubt the buyers have listed these companies and assets for sale because they are down in price based on short-term oil prices.
While I am bullish long term about oil and oil-related stocks, I am aware this is a time for caution. I have no idea how long Saudi Arabia and the Organization of the Petroleum Exporting Countries (OPEC) can keep oil prices at low levels, but if it lasts for six months or longer the debt-laden shale-related companies are going to have serious problems.
According to Fitch Ratings, there are currently some $300 billion of energy-related leveraged loans and high-yield bonds outstanding. A lot of those companies may have trouble making their coupon payments with sub-$70 per barrel oil, and the distressed asset firms could have a field day in energy-related bonds in 2015. Anyone considering putting new money into highly levered shale-related companies is just rolling the dice on their opinion of oil prices right now.
I ran some screens this morning and had no trouble finding oil and energy stocks that were cheap. However, when I dug into my tool bag to look for those that were also financially "safe," as measured by the Altman Z-score, the list shrank considerably. I have used Z-scores for years and find them a very reliable measure of safety. Companies with scores over 3 rarely experience serious financial difficulties.
One of the few companies to pass this screen is Tesco (TESO), a stock I did very well with back in 2011 when the shares traded below book value. Tesco makes top drives for drilling rigs and provides tubular servicers to the industry. Clearly, the company could see its earnings pressured if oil prices stay at this level for long, as drilling activity will slow across the U.S. However, the stock is trading back at book value and I will be an enthusiastic buyer if prices slip further.
I am also closely watching the options prices, as the January or March puts may be an attractive way to back into the shares by selling cash secured put that creates stock at 85% of book value or less. Tesco is debt free, and with a Z-score of 5.47, it should be able to survive long enough to thrive again when oil prices recover.
Independence Contract Drilling (ICD) is classic case of poor timing. The company had its IPO back in August and has seen its stock price plunge substantially on the decline in oil prices. It has 10 rigs operating in the Permian Basin in Texas as well as contracts for four more rigs to come on-line next year. The company's fleet consists of newer multidirectional rigs that should be in demand as long as oil prices do not fall into a black hole. A Z-score of 3.69 indicates the company is safe financially, and the shares trade at just 70% of book value -- definitely cheap.
I have no idea what will happen to oil prices in the short term. I was as surprised as anyone when the Saudis moved so aggressively to protect market share last month. What I do know, however, is that if prices stay low for too long, highly leveraged oil and gas companies will experience a great deal of difficulty and we could see a lot of defaults.
Equity buyers should stick with those energy stocks that are safe as well as cheap. The Z-score is one tool to use to stay safe in the oil patch.