Two Veterans of the Oil Patch Put the Current Down Cycle Into Historical Perspective

In the fall of 1995, Mike Kerr was a young oil and gas analyst visiting the site of a new discovery in Papua, New Guinea. After a long day spent examining the intricacies of the oil rig — thanks to the rugged terrain, a helicopter was needed to get around — Mike decided to join a half-dozen colleagues on a hike to take in the exotic scenery and clear his mind. The group came upon a handmade vine bridge traversing a deep gorge. As he made his way across the bridge, Mike heard a loud snap and felt the bridge give out from under him. “Okay, so this is how it’s all going to end,” he thought. Fortunately the bridge only dropped a couple of feet. He caught his breath and gently made his way off the bridge.

An experienced veteran of the oil patch, Mike knows all too well that harrowing experiences come with the territory. “Oil rigs are spectacular facilities, but they are very complicated, and if you don’t get things precisely right, you can get spectacular explosions,” he explains.

 

For some oil companies, the steep slide in oil prices that began nearly two years ago may also feel like a life-or-death experience. In February, oil was trading below $30 per barrel, a decline of more than 70% since June 2014. The plunge has forced many oil companies to slash investment, eliminate workers and decommission wells.

“We’ve seen this movie before,” says Mike, who has followed the oil and gas industry as an investment professional since 1985. Prior to that, he spent a few years working in the field as an exploration geophysicist. “Inevitably supply and demand will come back into balance and prices will stabilize. When will the cycle turn? Historically, it has been when the Saudis called an OPEC meeting and members agreed to production cuts.” In the meantime, those companies that get the key things precisely right can survive the downturn and come out the other end as survivors, says Mike.

 

 

Similar to the 1980s, when Mike began his career, oil prices today have collapsed because there is too much supply. In the U.S., technological innovation led to a remarkable turnaround in production as energy companies have greatly increased the extraction of shale oil. U.S. crude inventories reached 532.5 million barrels at mid-March — historically high levels for the time of year, according to the U.S. Energy Information Administration.

And it’s not just the resurgence of the U.S. shale industry that has put oil prices under pressure. Major oil producers around the world have experienced vigorous production growth in recent years, including Canada, Iraq and Russia. Oil producers are expected to generate an average
1.6 million barrels a day in excess of global demand throughout 2016.


"By the second half of 2016, every tank and swimming pool in the world is going to be filled with oil."
Robert Dudley
Robert DudleyCEO, BP, February 2016

After a period of prolonged investment, the industry was awash in liquidity, adds Frank Hu, a Capital Group investment analyst who has been covering oil and gas companies since 2003 and also worked in the oil industry for
14 years. “Prior to November 2014, we had several years of unprecedented high prices without much of a cycle,” Frank explains. “This created a backdrop where banks were willing to lend to oil companies freely. As a result, companies were borrowing to grow, which led to many of the excesses we see today.”

 

 

In the meantime, market forces are already starting to shift supply and demand back into balance. To survive the downturn, companies have reduced investment in exploration, halted plans to develop new sites, put off maintenance for existing projects and reduced staff. The total number of oil rigs in operation in the U.S. oil and gas industry fell to 480 in mid-March from a recent peak of more than 2,000, according to oil field services firm Baker Hughes. It’s the lowest rig count since 1940.

“The cuts in capital spending that are occurring right now in the oil and gas industry are incredibly severe,” notes Mike. “The industry is now acting in a massive way to correct the supply. And this is big stuff, because if you go back to 2014 some 25% of all capital spending in the United States was oil-industry spending.”

 

There Will Be Blood

Indeed, the pain felt by the oil industry today won’t necessarily translate into significant oil price gains right away. Excess supply pumped up global inventories, filling storage facilities to capacity. Furthermore, as Frank notes, oil projects take time to shut down. “The companies have to finish them because of sunk costs,” he says.

This predicament is nothing new, says Mike. “The oil industry seems to always overinvest at the top of every cycle and underinvest at every cycle bottom,” he explains. “And that hasn’t changed probably for 100 years. It will take three or four years to get this project queue of $100 oil out of the system, but a little down the road there’s going to be an inescapable void in supply. ”

At some point, the differential between supply and demand will be wiped out. When it does, prices will rebound. And absent the Saudis and OPEC stepping in to help manage global supply, consumers and investors can expect a much higher level of oil price volatility going forward. “Two years from now, if you go into a scenario where the global economy is improving, then you’re going to be in a situation where supply is going to be down – and you’re looking at another price spike,” says Mike.

 

How quickly companies can boost production when the cycle turns depends largely on how long the downturn lasts, says Frank. “You can’t just start this thing up. It takes time to get going again. And if prices remain low for the remainder of the year, the cost cuts companies will need to make are going to come at an extremely high price in productivity two years from now.”

Before ramping up for the next cycle, companies have to survive their current difficulties. In addition to cutting back on capital spending, many U.S. and Canadian energy companies have also slashed their dividends in an effort to preserve cash and strengthen their balance sheets. At current oil prices, the economics of the energy industry are highly challenging for a number of companies. “If prices stay low, a lot of companies are going to go to the wall,” says Mike.

 

Break-even costs vary across countries and companies — some companies may be profitable at $50 a barrel; others may have a break-even price of as much as $80 a barrel. Some companies must contend with heavy debt loads taken on to finance new projects. Inevitably there will be some industry consolidation.

Three Keys to Survival

Both Mike and Frank weigh many variables in their efforts to identify companies that can survive the current downturn and potentially thrive during the next cycle. They both work with investment professionals whose outlooks on the sector vary, but here are three things Mike considers key to survival for oil companies:

  1. A solid balance sheet. If low prices persist, companies that appear healthy today may run into difficulty. “I look for balance sheets that don’t have a lot of near-term financing needs,” Mike says. “A company can have a little higher debt than competitors, as long as the debt’s not due.”
  2. A superior resource base. “The oil price has corrected for a fundamental, serious reason,” says Mike. “Which companies have the sweet spots of the shale oil revolution? What companies can I invest in today that have strong and productive resources that can be developed when prices rebound?”
  3. Pristine accounting standards. “When you get into a price decline like this, there’s going to be all sorts of unpleasant accounting issues that come up because reserves are overstated, so I always want to make sure I’m invested where I think the accounting is most prudent, and where most of the bad news is probably already there.”

Who Stands to Benefit When the Cycle Turns?

Given the pain that the industry has already experienced, Mike believes this may be a great time for long-term investors to position for an inevitable turnaround. While different companies have different risk profiles, he says that dividend-oriented investors may want to focus on the larger integrated energy companies with diversified businesses, like Exxon Mobil or Chevron. “I believe the larger integrated companies with the stronger balance sheets will be able to sustain their dividends through the current environment. And, historically, they have been in a position to make acquisitions during prior downturns to enhance their businesses.”

And just as solid companies can be opportunistic during periods of market turbulence, so too can patient investors.

“I’ve seen many tough oil cycles. And what I have found is, in a bear market the harder you work, the more opportunities you may uncover. Periods like these can feel uncomfortable, but as a value investor I get excited,” he explains. “When markets are driven by momentum, hopefully we have the ability to look at individual companies and say, “This is a fundamental value.”


"When you know a business well, it changes your patience quota. The way you make money in this business is by being patient. You begin to see patterns that most people who’ve been doing this half as long can’t discern."