Are these oil companies set to be sunk by debt?


The collapse in the oil price from over $100 a barrel in 2014 to sub-$50 for much of this year has once again highlighted the danger of company debt for shareholders.

Time and again we've seen heavily indebted oil companies struggle to cut costs, conserve cash, sell off assets or find a strategic investor in order to meet interest payments or avoid breaching debt covenants.

Time and again we've seen temporary waivers and standstill agreements, and protracted negotiations with lenders.

And time and again we've seen companies ultimately forced to do a massive debt-for-equity swap -- leaving shareholders owning a tiny fraction of the business -- or else administration or liquidation, leaving shareholders with nothing.

Sadly, many investors in the likes of Afren (administration), Gulf Keystone Petroleum (debt-for-equity swap) and Xcite Energy (currently hovering between a debt-for-equity swap and liquidation) compounded their losses. They failed to appreciate the weak position of equity and the rapidly rising risk of suffering a capital wipeout or near-wipeout as the debt crisis unfolded. They boldly averaged down as the share price fell, seemingly unaware that debt was killing their company.

Two more at risk?

Premier Oil(LSE: PMO) and Igas Energy(LSE: IGAS) are two companies that could potentially be heading for trouble due to their high levels of debt. At a share price of 70p, Premier Oil's market cap is £358m ($437m), but net debt at its last balance sheet date (30 June) was $2.63bn.

The company has been getting monthly deferrals from its lenders on its debt covenants and expects these to continue "until negotiations with its lending group conclude."

Premier reckons that after a period of heavy investment, it can generate free cash flow at an oil price of above $45 a barrel, and thus begin to address its debt burden. However, the oil price remains precariously balanced. If it heads south again -- or if Premier has operational issues or costs are higher than expected -- lenders may not be as accommodating as they've been so far.

Risk ratcheted up

Meanwhile, Igas Energy has just been rebuffed by its main lenders. Secured bondholders turned down Igas's request for a temporary waiver of its daily liquidity covenants at a meeting yesterday. This decision ratchets up the risk for shareholders of the company, which has a market cap of £37.8m at a share price of 12.5p but net debt of £83.5m at its last balance sheet date (30 June).

Igas is set to breach its liquidity covenant next week, and in the event of doing so expects a grace period of 10 business days to allow it to pursue options to raise cash, remedy the breach and avoid default. It expects to be able to do this by selling bonds it owns itself or other assets.

The Board says it's continuing to pursue discussions for a longer-term solution to its debt problem, but the situation has become distinctly more ominous for shareholders in my view.

Due to their overbearing debt and the high risk to existing equity in a capital restructuring, I view Igas and Premier as stocks to avoid at this time.

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G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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