The world is awash in oil, or so it seems given the precipitous decline the price of the black gold. Naturally, opportunism is created in the investment world as share prices of energy related stocks are getting pounded.
The energy MLPs are among the hardest hit names. A lower oil price implies that their future cash flows, which are essential to the distributions they make, are going to get lower. Brietburn Energy (BBEP) has fallen about 30% in less than a month. If you look at a list of 52-week lows or stocks with the biggest percentage declines, they are littered with energy MLPs.
But when the price of a commodity like oil goes down, there are really two characteristics that will separate the quality investments from the traps. The first characteristic is the most significant: cost of production. The only competitive advantage a commodity business can truly have is being the lowest cost producer.
If your cost to explore and extract a barrel of oil is $50, you can still run your business and make money in this environment. But those business that have a cost of production start to lose. Some of them go bust, leaving even more business for the low-cost producers. Chesapeake Energy (CHK) is one such name in natural gas.
The other characteristic, which is really important in any situation or any industry, is debt. Because oil companies have a global commodity that is consistently demanded, the use of debt is encouraged and is optimal if managed correctly. Unfortunately, many companies don't manage debt correctly; they borrow as much as they can and often leverage up at precisely the worst time. When oil prices are high and cash flows are inflated, many companies take on leverage that is supported by those cash flows. Guess what happens when the price start falling and cash flows start shrinking?
For example, giant Exxon Mobil (XOM) has $15 billion in net debt, yet it generates $10 billion or higher in free cash flow per year. Rowan Companies (RDC) has $2 billion in net debt and tangible equity of $4.8 billion, which has one of the lowest debt-to-equity ratios in the space.
These two characteristics will protect your downside but inflate your upside when prices strengthen.