When it comes to the energy sector, history has a way of repeating itself.  Energy drillers purse debt-fueled growth when times are good and face a debt hangover when energy prices head south.

It’s happening again. The energy sector may face roughly $11.6 billion in bond defaults, according to a recent Bloomberg News article. Understandably, that has made many equity investors leery of this slumping sector.

#-ad_banner-#But has the commensurate plunge across the oil exploration and production (E&P) sector been overdone? And if so, might it  present a buying opportunity, both for investors and larger players?

The shale boom led to inflated asset values. Now, the reverse is true. The value of shale producer’s reserves have fallen more than 25% since 2013, from $18.52 per barrel to$13.60 per barrel at the end of 2014. That figure has likely fallen further in 2015.

I recently wrote about how the long-term demand for oil should help rebuild pricing. As a result, companies with near-term liquidity needs, but appealing longer-term fundamentals, could now be cheap enough to attract larger buyers.

Consolidation Has Commenced
We may already be witnessing asset-rich firms attracting the interest of cash-rich buyers.

For example, Whiting Petroleum Corp. (NYSE: WLL) saw its share price plunge at the end of last year on debt concerns. Rumors began that the company could be up for sale, which resulted in a 20% pop in stock prices. Since March 18, the price again dropped roughly 25%, bringing the share price back to around where it started the year.

Whiting took on a massive amount of debt last year to acquire Kodiak Oil & Gas’ proven reserves at $23.77 per barrel of oil equivalent. Whiting now has $5.6 billion in debt and just $78 million in cash on the balance sheet.

Buyers will most likely be larger players with lots of cash on the balance sheet and treasury stock to pursue deals. While shale reserves may not be strong assets now, oil prices will eventually rebound and North American shale represents a huge resource in a politically-stable region.

Exxon Mobil Corp. (NYSE: XOM) could be one of the biggest buyers. The integrated oil company is the only major firm with an AAA credit rating, which means it has access to the lowest rates on debt of any industry player. Exxon also has $226 billion of its own shares in treasury stock, ready to be deployed for a purchase.

XOM generates just 22% of its output from U.S. wells and has made a huge bet on Russian growth to drive future production gains. Snapping up domestic reserves could help balance future growth, especially if Russian assets don’t payoff.

Potential targets would be companies with high amounts of debt and low cash reserves, leading to a possible near-term liquidity crisis. Look for strong assets and a good history of production success for companies that might attract a buyer on long-term fundamentals.

Shares of Apache Corp. (NYSE: APA) have plunged 40% since the end of August 2014. The company has $11.2 billion in debt  and just $769 million of cash on hand. Apache’s operating margins sank over the last four years from 45% in 2010 to negative operating profits last year. Cash flow from operations was still $8.5 billion in 2014, but $12.4 billion in capital expenditures drove negative free cash flows.

Apache announced $5.2 billion in special charges last quarter, $4 billion in write-downs and a tax adjustment on foreign earnings. The company is slashing its U.S. rig count from 91 in the third quarter of last year to around 17 for 2015. This could help protect cash flow by lowering expenses and hold reserves for higher prices in the future. Apache has 2.2 billion barrels of oil equivalent (Boe) of proved reserves, 72% of which are in North America.

Continental Resources, Inc. (NYSE: CLR) has seen its stock price cut in half since August 2014. By the end of the year, the company had $6 billion in debt and $24 million of cash on hand.

CLR managed to book positive operating profits last year and a 31% operating margin, down from the 46% margins generated in 2012. Cash flow from operations increased last year to $3.35 billion, but that was still not enough to cover $4.7 billion in capital expenditures.

Continental has focused production in the Bakken with 1.17 million acres and 480,000 acres in south-central Oklahoma. Production increased 28% last year to reach a milestone of 200,000 Boe per day in December. Proved reserves totaled 1.35 billion Boe in 2014, up 25% from the prior year. Continental reduced its capital expenditure plans by 41% to $2.7 billion in March and is targeting cash flow neutrality by mid-year 2015. 

Against the upside to a buyout, remember that the investment could have a binary outcome. If oil prices stay low for an extended period, some of these companies could go into bankruptcy if a suitor is not found. The group will likely post high asset write-downs when Q1 earnings season gets underway in April.  Stick with the best of breed from the group and make it a small part of your portfolio.

Risks To Consider: There may only be two ways out for these companies, a quick rebound in the price of oil or a buyout by a larger company. Keep your investments small and spread over several candidates in case neither of these options plays out.

Action To Take –> Demand for E&P services is not going to go away even though low energy prices seem to have put the sector at risk. Take advantage of panic selling and near-term liquidity problems to snap up good deals ahead of larger buyers.

If oil, natural resources or commodities are what interests you, then look no further than StreetAuthority’s Scarcity & Real Wealth. Our resident natural resources expert Dave Forest has more than a decade’s experience as a trained geologist and analyst. His industry insight allows him to read the markets and provide the most timely, potentially lucrative advice for everything from oil and gold to molybdenum. Most recently, Dave has been talking about a rally in gold prices. To gain access to Dave’s latest research, click here.