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Where is the value in the oil patch?

Prices for oil and natural gas have fallen precipitously since the summer of 2014, bringing ample pain for oil and gas investors – not only have there been numerous bankruptcies, but also many companies that have survived have been forced to issue new equity at depressed prices, take on more debt if possible, and/or sell off prized assets in an attempt to survive the downturn.  Naturally, it begs the question: where can we find value and profit off of the current industry weakness?

Diving headfirst into the value chain

Before looking at this, let’s quickly recap the broad categories across the oil and gas value chain:

  • Upstream – exploring and producing hydrocarbons
  • Midstream – transporting hydrocarbons
  • Downstream – refining and selling hydrocarbons to end users
  • Service companies – assisting oil companies in exploring, drilling, and analysis

We’ll start with the service companies – firms such as Halliburton, Schlumberger, or Baker Hughes.  These companies provide a variety of services and products: some build the infrastructure to perform drilling, others actually do the drilling, and others still provide analytics or more niche services.  Many of these companies are well-run and have decent, if unexciting, returns on capital.  However, oil services tend to not be a huge long-run growth industry.  Here is the data on developmental wells drilled in the United States:

The data is very sensitive to the price of oil and total US production, but it is difficult to coax out a long-term growth trend.  Although developmental wills isn’t a perfect metric, you would come to a similar conclusion if you used the U.S. rig count.  Low, or even non-existent long term growth means we would need to buy a service company at a very low multiple of its potential earnings to justify an investment.  Although share prices of services companies have decreased, I haven’t seen any of these prices approach low-enough levels that I view as attractive.

Next we’ll address the downstream sector, which consists of both refining and retail.  Downstream profitability tends to be uncorrelated to oil prices, and even tends to move to some extent in the opposite direction, so in the current environment many downstream operators are doing quite well.  However, their stock prices largely already reflect these good results, thus preventing downstream from being an area where we will currently find large bargains.

Midstream companies are largely pipeline networks carrying crude oil or natural gas – while seeming straightforward to analyze on paper, they can in reality be fairly complex: many investors were drawn to their high dividend yields, steady cash flows, and (perceived) steadily increasing payouts – the prevailing notion being that profits were thought to be immune to fluctuations in the price of oil.  However, as crude and gas prices have cratered, earnings have fallen dramatically, leading to large losses for their stocks and in certain circumstances, even bankruptcy. Here is a graph of an etf tracking midstream performance:

Although there could very well be some value in this sector, midstream companies are outside of my personal circle of competence, which means that we wouldn’t make an investment even if the price seemed enticing – a stance I believe is prudent given that even experts have miscalculated industry dynamics, showing that very large mistakes can be made easily.

The last category is that consisting of upstream companies: those that actually explore and develop new hydrocarbon resources.  The profitability of these companies is largely beholden to the price of oil and natural gas, so in the current low price environment, many of them have struggled, again either facing bankruptcy or having their stocks lose a large portion of their value. Nevertheless, many of these companies have also been excellent performers over the long-term, so the current pullback could present good opportunities.

I’ve written on the oil markets a couple of times, and this article contains a more detailed discussion on my views of the market, but I want to quickly recap why I believe that certain upstream companies can be good investments.  As opposed to many other resource extraction industries, oil and natural gas is notable for the existence of decline curves – production at any given oil field must naturally decline over time due to physics and thermodynamics.  This means that new investments must continually be made to counteract production that is lost to decline each and every year. Furthermore, prices must maintain at high-enough levels over time to support this investment – if oversupply results in prices that are too low, investment as well as production will again drop (although this could take a few years); this will in turn create a shortage, higher prices, higher investment, and oversupply – and so the vicious cycle will continue.

Even in the IEA’s scenario where temperature levels are kept at an increase of 2 degrees Celsius over preindustrial levels, oil and gas investment will total nearly $13 trillion from 2015-2030 and will need to replace 4 “Saudi Arabias-worth” of oil production and 10 “Norways-worth” of gas production.[1]  It must be noted that the 2 degree scenario is an extremely optimistic projection for reductions in fossil fuel use.  Most estimates are for demand to be much higher than those levels, meaning that the required investment will most likely be well above the $13 trillion figure.  In order to spur this much necessary investment, prices will need to rise to a level that supports it – all of which means, finally, that the current drop in prices can’t last indefinitely.

Drilling down to find a winner

So given that there are several risks and obstacles facing upstream companies, but that the long-term economics look promising, what attributes should an upstream company have to make it a worthy investment candidate?  I suggest three:

  1. Good return on capital employed (ROCE)
  2. Conservative capital structure
  3. Integrated operations, if possible

Oil and gas extraction is a very capital intensive business, and many companies simply don’t earn good returns on the money they invest. Here is a chart of the returns on capital for five of the biggest oil companies taken from Exxon Mobil’s 2014 summary annual report.  Notice how, even in an environment where oil routinely averaged over $100 / barrel, Shell and Total only averaged about a 10% return on capital.  Even with oil prices at their highest point in history, these companies barely created any value for their shareholders, as they probably shouldn’t be doing hugely complex and risky projects unless they are going to return 10% at the very least.

We want to be investing in the companies that are well managed, capital efficient, and clearly generating value.

Regarding capital structure, oil and gas exploration is an extremely cyclical business, and these companies should be structured to survive a prolonged downturn.  Since a producer is at the mercy of market prices, and since prices often are low enough at the bottom of cycles so that no one is pumping profitably, these companies should not be financed with lots of debt.

Say someone told you that you could invest your money in a project that would return 15-20% of your money on average annually for 30 years, but that only every so often it would lose money for a couple of years at a time; you should invest your money in that project.  However, that said, it would still obviously be a terrible idea to finance that project with 40% debt – once the hard times come you would be unable to make the interest payments, and you would lose your interest in the project. This should be pretty obvious to everyone.  As evidenced by the 64 oil and gas companies that have gone bankrupt during this cycle alone, however, this wasn’t obvious to the managers of many of these firms.

Lastly, being an integrated operator simply means that an upstream company also has midstream and downstream operations.  While this is certainly not a requirement, it does help cushion earnings during low points in the cycle.  For example, in 2015 Exxon earned $7.1 billion in its upstream business and an additional $11 billion in downstream, enabling it to fund additional investments into the business and pay substantial dividends.

Who rises to the top of the barrel?

So, let’s look at the actual numbers.  Here is a chart of the 40 or so largest oil and gas companies with current net debt as a percentage of tangible capital, ROCE over the period of 2010-2014[2] (remember, oil prices were historically high in this period), the price in relation to its tangible capital, and an indication of whether the company is integrated or not.

We’ll look for companies with net debt / capital below 30% and an ROCE > 12%, as this will ensure conservative financial management along with good financial returns.  These parameters are not incredibly difficult to achieve (realistically I would prefer debt / capital < 20% and ROCE > 15%).  But even using this modest benchmark, here are the numbers:

I have highlighted the companies that have passed the two tests.  As you can see, not many companies pass.  The ones that do are Exxon Mobil (XOM), Chevron (CVX), Occidental Petroleum (OXY), Imperial Oil (IMO), Cenovus Energy (CVE), Pioneer Resources (PXD), and Cimarex Energy (XEC).

As I wrote in the last article, Exxon is intriguing at these levels.  To summarize, if the company can earn ~16% on its capital employed, increase its capital base around 5% / year (in line with historical growth), and trade at a range of 2-2.5x capital employed after 10 years (also in line with historical numbers with a strong oil market), then returns could be in the range of 13-15%. Those are attractive returns for any company, but they are made all the more attractive because of the investment’s defensive nature, steady growth, and global diversification – as oil and gas is an inherently risky business it helps to have your reserves spread across the globe.

Having Exxon as your “base case” also helps to look at the other companies through that lens.  Should I invest in a smaller, less well capitalized, less well run, less geographically diversified company if I can invest in Exxon?  The answer can hypothetically be yes, but only at the right price and acknowledging that there is more risk.

Going through them, Pioneer and Cimarex primarily drill in the Permian Basin, which is some of the best acreage in the US, if not the world.  However, you can see that their operational returns aren’t as good as Exxon’s and their shares are more expensive.

Cenovus and Imperial[3] are, likewise, interesting, but their operations are located in the Canadian Oil Sands, which generally have higher operating costs. In a lower-for-longer energy price scenario, these companies might not be able to earn great returns on capital. Not to mention, you also run the risk of not being able to cost-effectively bring the oil to market; at one point earlier this year I read of producers in Canada only getting ~$8 / barrel for synthetic crudes because of high transportation costs of around $18 / barrel.  In a political climate where midstream projects are routinely rejected, not being able to cost effectively bring oil to market is a major long-term risk.  Lastly, when production is concentrated in one area, freak acts of nature like the gigantic wildfires that disrupted Canadian operations can occur at any time.

The last two companies, Chevron and Exxon, are interesting.  Chevron offers much of what Exxon does, although at a slightly lower level of efficiency. Still, this is somewhat mitigated by the fact that it is much cheaper in relation to its assets.  The determination of which will perform better over time likely depends on oil prices (lower prices favor Exxon) and the extent to which Chevron can profitably bring some massive new projects online.  Either way, I would expect returns to be fairly similar for both of them. Occidental, on the other hand, offers something slightly different.  The company is well run but is significantly smaller than either Exxon or Chevron. Also, it has historically increased its capital and production at higher rates than those two, and while many of the independent companies have grown quickly but at low returns (as the chart shows), Occidental has done so very profitably.  The company could prove to be a good value if it can continue its profitable growth.

Closing thoughts

Going through the different sectors of the oil and gas market, there could be value in some of the service providers and midstream companies, but for me, overenthusiasm and complex economics, respectively, keep me away from those shares.  It looks like there could be some value in some select exploration and production companies, but caution is warranted here as well – many of these companies are either excessively levered or simply spent too much money chasing production in the good years, leaving their companies with low returns on capital.  As many are in rather precarious financial positions, bankruptcy or dilutive equity raises are real risks for these companies if oil stays lower for longer, so their shares could appear cheap for good reasons.  Among the companies that are profitable and conservatively managed, Chevron and Exxon seem to offer the prospect for good, long-term returns along with the benefits of global resource diversification; and then among the handful of still remaining companies, Occidental could be a good alternative, with higher growth and less payouts.

[1]https://www.chronosoilandgas.com/News/Read/301/statoil-185-trillion-will-be-needed-in-o-and-g-investment-to-meet-future-demand

[2] This number is estimated as cash from operations minus D&A with an adjustment for interest paid divided by capital employed (book value + total debt).  Taking CFO instead of net income helps adjust for asset impairments or spinoffs which can affect net income and therefore ROCE.

[3] It should be noted that Imperial is majority owned by Exxon.

Disclosure: My clients and I are long XOM.  Some clients are also long CVX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am a registered investment adviser. However, this commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.

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