Warning: Sell This Driller -- Before It's Too Late

By
A A A

It's been nearly a decade since the shale revolution began. Suddenly, the U.S. was being referred to as the "Saudi Arabia of natural gas," and hundreds of companies decided to spend massive sums of money to explore shale formations.

#-ad_banner-#It was a heady time, with dreams of future riches. Yet, as they'll tell you in business school, you should only invest money in your business to the extent that future cash flows will benefit. Otherwise, you'll go bankrupt.

That's the sad lesson now being learned by executives at Forest Oil (NYSE: FST ) . The company has been on a spending bender for quite some time -- with little to show for it.
Blame goes a series of once-promising wells that never really produced the oil and gas as expected. As a result, Forest Oil's cash flow statement can make you wince.

If you are wondering how a company that already carried nearly $3 billion in net debt at the end of 2008 has managed to stay afloat despite massive annual negative free cash flow, the answer lies in asset sales -- many of them. Forest Oil has sold off many of its most promising oil fields to pay off bonds that have come due at various intervals.

Forest's long-term debt has fallen to $800 million (as of the end of 2013), but that is still too much for its lenders, and as a result, the company recently cut a new deal to avoid an imminent breach in debt covenants .

As noted by Bloomberg, Forest can now hold a level of debt that is less than 5.75 times annual operating cash flow. Analysts at Goldman Sachs calculate that Forest will generate $128 million in operating cash flow this year, meaning debt must remain below $736 million. Presumably, recent asset sales will reveal a drop in debt from the $800 million figure seen at the end of 2013. (Forest will report first-quarter results on May 6.)

That mandated debt-to-cash flow restriction eventually tightens to 4.5. Luckily for the company, operating cash flow might eventually rise to $200 million, according to Goldman Sachs. More troubling, this is still a company that is addicted to living beyond its means. Let's look at the numbers again, though this time with a forward view.

According to Goldman Sachs' forecasts, Forest Oil is likely to generate negative free cash flow for the next three years. It would be nice to think that the company can just make more asset sales to raise fresh cash and stave off creditors. But the current cash flow targets that the lenders are anticipating will be hard to meet if there aren't enough assets to produce them. The best thing that could happen to Forest Oil would be a massive spike in oil or gas prices -- but that is no way to run a business.

Moody's which downgraded Forest's bonds to B3 (Negative) in early March, before the debt covenants were loosened, noted that "Drilling results in Forest's Eagle Ford Shale are short of expectations, which we previously stated could be a catalyst for a downgrade," adding that "the reallocation of capital away from the Eagle Ford will result in lower oil production than we had previously anticipated, leading to reduced cash flow and higher leverage ."

When Forest announced some relief from lenders in the form of looser debt covenants on March 31, you would have expected shares to stage some sort of relief rally. Yet shares remain stuck below $2 anyway. Investors clearly understand that this company, which has a litany of missed cash flow targets under its belt, may once again fail to deliver enough cash flow to satisfy lender covenants.

Risks to Consider: As an upside risk, yet another asset sale, at an impressively high price, could loosen the noose around this company's neck just a little.

Action to Take --> Forest Oil is selling off the furniture to pay off the mortgage, yet the ongoing robust capital spending plans (which are leading to further free cash flow losses) is akin to buying a new TV set, even though there's no couch to sit on. This stock has potentially 100% downside if management decides to seek bankruptcy protection, or the bank grows tired of loosening the debt covenants.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Stocks

Referenced Stocks:

StreetAuthority

StreetAuthority

More from StreetAuthority:

Related Videos

Stocks

Referenced

Most Active by Volume

64,789,752
  • $117.60 ▼ 0.86%
53,107,118
  • $10.39 ▼ 1.05%
42,600,857
  • $17.10 ▼ 0.47%
36,917,582
  • $11.02 ▼ 0.36%
34,902,121
  • $40.75 ▼ 0.10%
31,489,742
  • $15.68 ▲ 0.06%
31,037,743
  • $75.63 ▲ 2.19%
29,605,187
  • $10.11 ▼ 0.69%
As of 11/25/2014, 04:15 PM

Find a Credit Card

Select a credit card product by:
Select an offer:
Search
Data Provided by BankRate.com