Independent capital for independent producers.

Déjà Vu All Over Again (Again)

Posted on January 24, 2018 in Arthur N. Budge, Jr.

Those who have read my articles over the last 25 years know my favorite Yogi Berra quote: “It’s déjà vu all over again.” This is such an apropos description of the oil business I can’t resist continuing to use it frequently.  In this article, I will discuss how the oil and gas industry went from boom to bust and how Five States as a value investor intends to take advantage of the opportunities the bust has created.

The oil and natural gas industry is very cyclical. Oil and natural gas supply and demand are very price inelastic[1].  This results in small changes in supply or demand having a material impact on wellhead prices.  Drilling projects require large capital investments with long cycle time between commitment and deployment.

Producing oil and natural gas properties[2] have a lot of operating leverage[3].  During periods of expansion, “Wall Street types” want to “teach” oil producers “financial engineering” (financial leverage, i.e. using more debt).  This increases total leverage, further increasing fixed costs, thereby increasing risk and volatility.  The combination of these factors results in a recurring pattern of boom and bust.

Today we see the cyclical pattern playing out again. Too much oil production has resulted in lower oil prices.  The oil patch is in the middle of a financial wash-out due to lower wellhead prices combined with too much debt.  The U.S. is once again the world’s largest oil producer, providing the increased supplies that caused oil and gas prices to fall.  Capital investment in new development (outside of shale) is slowing around the world.

These cycle changes are normal for this industry that has enabled the creation of our modern economy. Consensus is that the U.S. will remain the world’s marginal oil producer for the next decade or longer[4]. The U.S. can currently produce as much oil as the world economy demands, but only at high prices.

By the most optimistic forecasts, solar, wind and other renewables will not have a major impact on world oil or natural gas demand for at least a decade or longer. Neither will electric cars.  The most impactful change is the shift from coal to natural gas as the primary fuel used to generate electricity (natural gas now exceeds coal and will continue to take market share from coal[5]).  For the next twenty years, world demand for oil and natural gas will continue to increase, depleting the lowest cost shale formations which over time will result in rising prices.

World Supply and Demand and Future Oil Prices

Oil trades in a world market. Oil prices are a function of world-wide supply and demand. Despite increased U.S. production, if world demand grows faster than world supply the price of oil will increase.  Almost all major forecasts predict increased demand for oil over the next decade.[6]

Future prices for natural gas are less clear. Natural gas is the most logical fuel to transition the world away from coal as the world’s primary energy commodity.  It provides the most environmental benefit per dollar invested (more than solar or wind).  However, U.S. reserves are so plentiful that it may take a long time for the price of natural gas to increase materially.

The U.S. shale boom resulted in a huge reversal in oil and gas supply trends. The development of unconventional resources (production from shale formations) resulted in a renaissance in oil and natural gas development in the U.S.  These new U.S. shale deposits account for more than 80% of total world shale oil reserves.  By comparison, the Energy Information Administration (EIA) estimates total world conventional proven oil reserves to be 1.7 trillion barrels, and unconventional reserves to be 5 trillion barrels.  The U.S. now has over half of the proven world oil reserves.  However, much of these reserves are only economically viable at prices over $60 per barrel.

Increased supply from shale production has resulted in lower world oil prices and the belief that the U.S. can become energy independent. But the EIA, in its Annual Energy Report 2017[7], projects U.S. shale oil production in the U.S. will peak in the next decade. The peak may be reached as early as three to five years from now, or it could take ten years or longer.  Given that 80% of the world shale reserves are in the U.S., it is likely world shale production will peak near the same time as U.S. production. Unlike oil, the unconventional natural gas supply in the U.S. is expected to last for decades without any impact on the ability to develop new supplies.

Prohibiting exports would not make any difference. In fact, allowing free trade in oil and natural gas should result in slightly lower world prices. With a near “unlimited” supply, natural gas prices will be determined by the marginal cost to produce natural gas relative to demand, and thus should remain around current levels.  The U.S. will remain a net importer of oil for the foreseeable future, but should become a major net exporter of natural gas.

According to the EIA we have plenty of oil and natural gas. The key questions from an investor standpoint are “at what price?” and “for how long?”  Maintaining the supply of unconventional crude oil will require higher prices[8].  A widely accepted estimate is that crude oil needs to be above $60 per barrel to sustain current production volume.  Recently we have seen improving statistics on a cost per barrel (oil) basis and cost per mcf (gas) basis.  But as the best shale oil reserves are depleted, the sustainable wellhead price per barrel must increase to support the development of lesser quality reserves.  Over time, the trend will revert to upward pressure on oil prices.

 

Value Investing Defined

Motley Fool defines value investing as “investing in assets trading at prices below their Intrinsic Value. Value investors, therefore, are essentially buying assets at a discount to what they believe they are worth, in hopes these investments will eventually rise to reflect their Intrinsic Value.

To better understand value investing, investors should understand a few related terms:

  • Intrinsic Value: An estimate of an asset’s worth. Importantly, intrinsic value differs from an asset’s Market Price in that it represents the calculated present value of the underlying income stream.
  • Market Price: The price at which an asset is trading at any given time in the asset’s market. Value investors hope market price volatility will occasionally drive an asset’s market price irrationally below its Intrinsic Value, thus creating a value investing opportunity.”[9]

Five States applies this logic to investing in proved, producing oil and natural gas properties. However, there is one caveat to the Motley Fool definition.  If oil and natural gas properties can be purchased for their Intrinsic Value, an investor can earn the implied rate of return as current income over time from owning the asset.  The investor does not have to sell the asset at a Market Price exceeding the Intrinsic Value to make a profit.

The Intrinsic Value of a property is calculated using traditional fundamental analysis.  Engineering forecasts on the future production volume from a developed field are prepared.  Forecasts of production volume on mature, proved developed fields tend to be very accurate in a portfolio context.  Future oil and natural gas price forecasts and production expenses are then used to calculate our forecast of Present Value[10] of projected future income.  A standard reference discount rate is 10%+/- (before the impact of G&A and any debt leverage).  This is referred to in the industry as the PV10 value (PV for present value, 10 for the 10% discount rate).

A buyer may adjust the discount rate up or down depending on his subjective assessment of risk and quality of the producing properties. The likelihood of more income than forecast over the long-term from future development that is not included in the projected income may also be a factor in using a lower discount rate.  If the Market Price of a property is at or below the Present Value of future projected income (the price that generates our target rate of return), a value investor will buy it.  If not, they would pass.  Most of the time during the last decade, the Market Price of producing properties has been higher than the Intrinsic Value.  Over the last three years, this trend has reversed.

Value Investing requires discipline, and results in very few exciting transactions. It tends to be a slow return process.  An investor must wait to invest when the Market Value is greater than the Intrinsic Value.  It can be like a day of fishing where they don’t bite very often.  You get frustrated, but over time you catch enough to get you to keep putting your line back in the water!

I find Value Investing the most logical way to deploy capital in the oil and gas sector.  But it requires patience, discipline, and can be counterintuitive in execution.  The best time to buy often does not feel right. Intrinsic Value often equals or exceeds Market Price following a decline in the overall sector, when investors are hurting from overpaying when the Market Price was higher than Intrinsic Value.  Market momentum does not matter in Value Investing.

Over the last several decades, most Value Investing has been in the form of private equity.  In the public markets, the most successful investors were executing growth strategies that benefited from declining interest rates through price/earnings expansion[11].  Since the early 1980s, investors have been willing to pay ever higher prices, in essence accepting ever lower yields, for stocks and bonds.

Private equity investors using value strategies have been able to compete in part by capturing the Liquidity Premium[12] inherent in illiquid assets.  They could then arbitrage the difference between the private and public market valuations on exit, by buying in the private market and selling in the public market.  Examples of the Liquidity Premium are easiest to see in real estate and oil and gas.  Real Estate Investment Trusts (REITs) and energy Master Limited Partnerships (MLPs) have traded at 1.5 to 2.5 the private market value of the underlying assets.  This has always seemed like a huge premium for liquidity to me.  With interest rates bottoming, the arbitrage potential has become less available.  However, the liquidity premium can still be captured through new investments in oil and gas properties.

Value Investing in the Oil Patch

The Market Price of producing oil & natural gas properties is a function of three factors:

  • Expected Future Price of oil and natural gas and expenses
  • Discount Rate on which the Present Value of properties is being calculated
  • Sentiment, manifest in Availability of Capital and Supply of Producing Properties for sale

Future Prices are currently much lower than they were forecast to be a few years ago. This has resulted in a decline in the value of proved producing properties of two-thirds to seventy-five percent[13].  A property that would have sold for $1 million or more in 2014 has a present value today of $250,000 – $350,000, and can be purchased to generate first year free cash flow of over 10%.

Discount Rates currently used by the market when calculating the Present Value of properties are “reverting to the mean.”  When properties could be financed with debt at 4% to 8% interest, competitors were using discount rates of 8% or lower.  Now that “cheap leverage” is no longer available, discount rates are reverting to the long-term range of 8% to 15%.

Sentiment is more negative than it has been since the late 1990s. The discipline of Capital Rationing[14] has returned to the oil and gas industry. Capital Rationing reflects a limit of capital available to a business relative to the amount of investment opportunities they have that are projected to generate a return higher than their cost of capital.  Capital rationing has historically been the norm for the oil and gas industry. An oil company almost always has more investments it projects to be profitable than it has access to cash with which to drill those prospects.

During the boom oil companies could get all the funding they wanted for almost any project. Many projects that were funded are not profitable at current wellhead prices.  Most new acquisitions made toward the end of the boom when oil prices were higher will never achieve payback of the investment.  Many oil companies are now in a debt or liquidity squeeze. Debt levels that three years ago looked conservative have proven to be excessive. Capital investments in oil and gas are now more disciplined, providing a greatly improved environment for deploying new capital. This is providing both an increased supply of assets available for purchase and an improved environment for companies like Five States who are making new oil and natural gas investments.

Conclusion

2018 is starting to feel a lot like the 1990s:

  • Oil & natural gas properties can be purchased on attractive valuations based on today’s wellhead prices.
  • Intermediate to long-term expectations are for higher oil prices. But the Market Price of producing properties today does not reflect material increases in oil prices over the next decade.
  • Capital rationing is creating a greater supply of mature properties than has been available for purchase in over ten years.

This sets up a great fundamental investing opportunity:

  • Market Values are once more aligning with Intrinsic Value. Producing properties can be bought at the most attractive value available in over a decade.
  • Current Yields on producing properties are extremely attractive compared to stocks, bonds or real estate. Yields on newly acquired mature producing properties can be expected to exceed rates currently available from junk bonds with much better “collateral coverage”.

This provides an ideal Value Investing opportunity.  New investments will provide an attractive yield to cover the “time value” of owning properties.  At the same time, an investor has a “free option” on the upside potential in oil prices. Under this scenario, the timing of the inevitable increase in prices is unimportant.  An investor can collect an attractive yield each year while waiting for the price increase.

The key to success will be accumulating good quality, long-lived production at or below Intrinsic Value and managing and administering those assets efficiently. This is the basic strategy Five States executed in our first twenty years.  It really is like déjà vu all over again (again)!


[1] Inelastic is an economic term used to describe the situation in which the quantity demanded or supplied of a good or service is unaffected when the price of that good or service changes. Inelastic means that when the price goes up, consumers’ buying habits stay about the same, and when the price goes down, consumers’ buying habits also remain unchanged. https://www.investopedia.com/terms/e/inelastic.asp

[2] Producing oil and natural gas properties are defined in this article as oil and gas wells that have been drilled, completed, and on production for several years. This provides historical production and operating expense data for forecasts of future income.

[3] Operating Leverage describes businesses or assets with a high fixed cost structure. Businesses with high operating leverage cannot reduce their costs when prices for their product fall. This results in a rapid erosion of their profit.

[4] https://oilprice.com/Energy/Energy-General/U.S.-Shale-A-Marginal-Not-Swing-Producer.html

[5] https://www.eia.gov/tools/faqs/faq.php?id=427&t=3

[6] Energy Information Administration (EIA) International Energy Outlook 2017, page 35

[7] Energy Information Administration (EIA) Annual Energy Outlook 2017, page 43

[8] Energy Information Administration (EIA) International Energy Outlook 2017, page 13

[9] https://www.fool.com/investing/2016/12/09/what-is-value-investing.aspx  I substituted “asset” for “stock”.

[10] Present value (PV) is the current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows.  https://www.investopedia.com/terms/p/presentvalue.asp

[11] Price/earnings expansion defined https://seekingalpha.com/article/4128629-price-earnings-ratio-expansion-explained-care

[12] Liquidity premium is a premium demanded by investors when any given security cannot be easily converted into cash for its fair market value. When the liquidity premium is high, the asset is said to be illiquid, and investors demand additional compensation for the added risk of investing their assets over a longer period of time since valuations can fluctuate with market effects. https://www.investopedia.com/terms/l/liquiditypremium.asp

[13]

The decline in the value of properties is discussed in my 3rd quarter 2015 article in The Producer.

http://fivestates.com/change-in-the-oil-industry-and-the-impact-on-five-states/

[14] Capital Rationing in the Oil and Gas Industry is discussed in detail in my 1st quarter 2015 article in The Producer of the same name. http://fivestates.com/capital-rationing/