The News is So Bad!

I have received a number of calls recently with a common theme; “The News is So Bad!” This statement is usually followed by:

  • “I read that the price of oil/gas will never recover”;
  • “The drilling industry is collapsing”;
  • “I read that the collapse of the oil/gas industry may go on for decades”; or
  • “How can we make money if oil/gas prices don’t recover?”

For value investors, this is as good as the environment gets for making new investments!

The Boom

The boom in oil and gas was driven by several factors. The first was growth in world demand. Despite slowing growth in energy demand in the developed economies (the US, European Union and Japan) primarily due to more efficient use of energy, world demand continued to grow over the last decade. Total energy demand from the emerging economies (China, India and others) is now greater than from the developed economies. The rate of growth in demand by the emerging economies has slowed in the past few years, but world energy demand continues to increase every year.

World Oil Demand

The increase in energy demand resulted in higher prices, which led to the development of unconventional oil and gas development. The method of development is not what is unconventional. Hydraulic fracturing has been used throughout the world since the 1950s. The unconventional part is developing shale formations, which is not economically viable when oil is less than $40 – $50 per barrel. When oil was over $80 per barrel, there was a “gold rush mentality” in the industry, with attempts made to develop almost anything that would produce.

The development was very successful. The majority of the new production developed was in the US. Domestic oil production increased by two-thirds over the last decade, from six million barrels per day to over 10 million barrels per day. Last year, the US was the world’s largest oil producer. But this led to excess deliverable supply and a price collapse.

US Oil Production

Too Much Debt

The boom and subsequent collapse were fueled by a combination of success in drilling and too much debt. The location of the shale formations is well understood and documented, so few dry holes were drilled. This led to the perception that drilling shale wells was not risky, so greater levels of debt were used to capitalize the development than was historically normal.

Oil Price and Unexpected Market Tightness

Debt and Leverage Have Increased Sharply in the Energy Sector

Since interest rates were low, the addition of low interest debt to the capital structure of oil companies became common. The “cost of money” to develop or buy oil properties decreased tremendously.

Historically, good quality proved producing oil properties were valued at a 10% – 15% discount rate. That is, the value of the estimated future income stream is valued at a price that would generate a 10% – 15% net yield over the life of the well.

Low cost debt resulted in the discount rate declining into the 6% – 8% range, increasing the market value of these wells by two to three times or more. And these yields were being calculated on assumed future oil prices continuing at record levels.

Record Prices and Production Volume

Until late 2014, oil was selling for record prices, ranging from $80 – $140 per barrel. The consensus view was that oil would continue to sell for $80 – $100 per barrel. It was assumed it would “spike” above that range during periods of international instability, and that any declines below that range would be short-lived.

By late 2014, world production began to increase to a level greater than world consumption, as demand growth began to slow. Inventories reached historic highs, and prices collapsed. US production has peaked, and is expected to decrease by 700,000 barrels per day this year.

When Do We Buy?

I am often asked “How do we call the bottom?” The answer is, we can not. I have no idea if the bottom was last quarter or if the price of oil will decline again later this year.

However, it is time to buy. We are clearly in the bottom quartile of the cycle. Oil prices are low and discount rates are high. There is “a lot of money on the sidelines,” but most of it is focused on public companies and assets over $100 million.

We believe that over half the oil and gas companies in the US are insolvent. The values of producing properties have decreased by over 80% in the last two years. Many of the transactions will be liquidations of companies. We expect more assets to change hands than in the 1990s.

What’s the Deal?

The answer to the original question is, we will make money by owning income-producing assets. Producing properties are at a value that generates a double digit current yield based on current wellhead prices. Little, if any, value is being paid for future development potential.

We will be using forward sales (“hedges”) to lock in the price of the majority of our production for four years. This ensures that if we are early and prices are lower over the next few years, we will have “locked in” the double digit yield over this period, and be almost certain we have made a profitable investment.

By using hedges, we are giving up the potential to earn superior returns in the short-term. I like this trade. It allows us to accumulate high-quality, long-lived assets, which will earn a very attractive current yield while we wait for an intermediate-term recovery in oil prices which we believe is inevitable.

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