Tullow’s timely lesson for bets on battered energy stocks

The search for unfairly undervalued energy investments is peppered with difficulties

Tullow Oil’s stock market meltdown is a sharp reminder that trying to bet on a rebound in heavily indebted energy companies is tough.

The UK-listed oil and gas explorer suffered a more than 70 per cent drop in its market value on Monday, after it ousted its chief executive while cutting its production outlook.

Retail punters in the FTSE 250 company’s stock, who jumped in after the 2015 oil price slump believing it was a chance to snag a quality investment at a temporarily depressed price, will be ruing the day they stumbled into a “value trap”.

But a look across the Atlantic shows that even the most sophisticated investors — the masters of the universe who work at Park Avenue hedge funds — have fallen on their faces betting on recoveries at energy companies with strained balance sheets.

It is easy to see what drew them in; that collapse in oil and gas prices in 2015 wreaked far greater havoc in the US, particularly given the large share energy companies occupy in the junk bond market.

For hedge funds that specialise in investing in the battered equity and debt of troubled companies, this appeared to be the opportunity of a lifetime. New funds sprang up specifically to take advantage of the blood in the streets.

This rush of capital allowed many US businesses to raise fresh equity, a path that Tullow Oil itself followed when it tapped its shareholders for $750m in 2017. Other high-profile struggling firms, such as shale gas stalwart Chesapeake, coaxed investors into debt exchanges, in which lenders pushed out the date when loans came due, in return for greater security on assets.

The belief that helping these businesses through short-term difficulties would reap rewards has come undone this year, as profitability and cash flow issues have stubbornly persisted. Riskier US energy bonds now yield on average nearly 10 per cent, compared with less than 6 per cent for the broader junk bond index.

Worse, those dismal index-level statistics mask how acute the pain has been at specific oil and gas companies that were darlings of distressed debt specialists.

Chesapeake shocked the market last month when it warned it may no longer be able to keep the lights on as a “going concern”. While the Oklahoma-based company has since hashed out yet another deal with its lenders, its longer-term bonds are still trading at around half of their face value and its stock is down more than 60 per cent this year.

The list of investors that have stepped on such rakes reads like a who’s who of US credit hedge funds. Blackstone’s powerhouse debt unit GSO and well-known distressed hedge fund Solus have both suffered from bad bets on energy companies.

The fresh distress is, of course, bringing a new wave of investors sensing opportunity. Hindsight will one day allow us to judge whether this is heroic or foolish.