The energy market is back on the rise after a two-year decline, and today many investors have a renewed interest in this industry. Increasing oil prices should lead to higher production rates and high levels of drilling activity, a great situation for just about everyone involved.
But that doesn't mean every stock in this industry is ready to run again. In fact, there are quite a few duds. So we asked three of our energy contributors to each highlight a stock they think is a terrible investment. Here's why they picked offshore-rig owner Seadrill Limited (NYSE: SDRL), oil refiner Calumet Specialty Products Partners (NASDAQ: CLMT), and exploration and production company Cobalt International Energy (NYSE: CIE).
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Years of terrible capital allocation make it easy to hate Seadrill
Jason Hall(Seadrill): A few years ago, Seadrill was a dividend darling -- a company producing gobs of profit and paying a fat dividend. But at the same time, management was leveraging the company to the hilt, adding billions in debt to fund its growth ambitions.
Here we are today, with the company facing billions in debt maturities in the coming months, and a risk that it won't be able to refinance that debt before it's due. That threat has pushed what was once a stock above $50 per share down below $2. That's less than half as much as the company's annual dividendwas a couple of years ago.
And while there's still a good chance management could work out a deal with its bondholders and lenders, it's not clear how much any deal could further harm existing shareholders simply to save the company. Bottom line: Seadrill managed its capital terribly during the oil boom, and investors are now paying the price -- and that price could get steeper. The current management team is doing its best to right the ship and preserve the company, but the damage to long-term investors has already been done.
Tyler Crowe (Calumet Specialty Products Partners):Some companies are just too toxic for investors to touch, and Calumet Specialty Products Partners is one of them. While a part of the business does look attractive from an investment perspective, all the things that come with that decent-looking business make the juice not worth the squeeze.
Calumet is structured as a master limited partnership which, in theory, delivers high-yield distributions to shareholders from cash that the underlying business throws off. For this process to work, though, you need a business that can generate a steady stream of cash in both the ups and downs of an industry. Calumet's specialty product manufacturing business would seem well fitted to this market, since it has rather consistent margins. The rest of the business -- fuel refining and oilfield services -- are in notoriously cyclical industries.
Even with some financial wizardry such as derivatives and futures contracts, a refiner and oil-services business can't completely isolate itself from commodity price risk. As a result, cash flows have completely dried up, and refining margins across the U.S. have narrowed. Without these two businesses running at a normalized rate at minimum, it's almost impossible for Calumet to meet its cash obligations.
To make matters worse, the previous management team loaded the company up with debt that's making it virtually impossible to generate a profit. Today, its total interest expense is greater than EBITDA, leaving little for the bottom line.
Perhaps Calumet can remake itself around its specialty products manufacturing segment. If it were to do so and chip away at its debt load, then perhaps it would be worth revisiting. Until then, this is an oil stock to be avoided at all costs.
Just don't go there
Matt DiLallo (Cobalt International Energy): Through the first nine months of last year, Cobalt International Energy generated a mere $13.7 million in cash flow from operating activities. At the same time, it spent $510 million on capital expenditures alone, as it continued its quest to find and develop offshore oil fields. What's even more remarkable is that last year was the first time in the company's 10-year history that it actually produced a drop of oil and generated operating cash flow. That shows just how long it can take to turn offshore discoveries into production.
Cobalt is still a long way from being a self-sustaining company, because most of its oil discoveries are still in the appraisal phase. That means the company needs more time, and even more money, to generate the production necessary to sustain its current spending level. What's worse is that the company is burning through what cash it does have and has few options to raise the capital it needs to complete its development projects. That means it must sell assets, issue equity, and pile on more debt to build out its production capacity in the years ahead.
That capital was easier to obtain when oil was in the triple digits, because investors were pouring money into offshore development projects. However, with the price ofcrudehalf what it once was, most new capital is going into lower-cost onshore sources, which can produce returns in months instead of years. Given these market dynamics, investors should steer well clear of Cobalt's stock. It's just not worth the risk.
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Jason Hall owns shares of Seadrill. Matt DiLallo owns shares of Seadrill. Tyler Crowe owns shares of Seadrill. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.