From the April 2013 issue of Research Magazine • Subscribe!

April 1, 2013

Moving Ahead

The 2013 Oil & Gas Investment Roundup

The United States continues to move toward energy independence with oil-and-natural gas industry exploration and production (E&P) companies playing an important role in that trend. Research asked five industry experts for their views on the sector: 

  • Andrew Coleman, managing director E&P Research, Raymond James Energy Capital Markets; 
  • John Dowd, portfolio manager of the Fidelity Select Energy Fund; 
  • Michael Forman, CEO, Franklin Square Capital Partners; 
  •  Tim Guinness, chief investment officer and fund manager, Guinness Atkinson Funds; and 
  • Will Riley, fund co-manager with Guinness Atkinson Funds. 

How did the E&P companies that you follow perform over the past year or two?

Andrew Coleman, Raymond James: Last year, one-third of our covered names saw share prices advance, while two-thirds saw share prices decline. The average return was negative 6.9%. 

John Dowd, Fidelity: The group as a whole, if you look at the S&P Composite Energy Index, has basically been flat over the past year or two. If you look at calendar 2012, the group was up and had a total return of 2%. In calendar 2011, it wasn’t so different—it was down 7.6%. So, the group’s been trailing the S&P 500.

Will Riley, Guinness-Atkinson: We follow approximately 50 U.S. E&P companies in the United States and 26 non-North American E&P companies with market capitalizations over $1 billion. We divide the U.S. universe into gassier E&Ps, oilier E&Ps and mixed oil and gas E&Ps. 

In 2012, the oilier part of the U.S. universe was up 1%, the gassier down circa 6% and the mixed down 5%. In the first seven weeks of 2013 the oilier were up by 5%, the gassier by 4% and the mixed by 6% ... 

The international E&Ps as a group performed better than their U.S.-opposite numbers and were up about 20% on average over the period with strong performances from [some] stocks … up over 60% (and beneficiaries … of strong Brent pricing). 

Did these recent results differ significantly from your expectations? If they did, what factors caused the unexpected results?

Coleman: Last year, given a litany of economic and industry headwinds (e.g., U.S. fiscal cliff, a U.S. presidential election, weak economic growth in Europe, the U.S., and China, and rising production on both the gas and oil front), we expected shares of E&Ps to fall in the plus-or-minus 5% range, so were comfortable with that prediction and the actual results bore that out.

Dowd: In general, yes. I think one of the big surprises has been that the agents of energy independence, the companies driving the growth in U.S. oil and natural gas, have not actually benefited from a stock perspective. If we read the front page of almost any newspaper, people are talking about the potential for energy independence in the United States. And I think one of the big surprises has been that the companies that are making that happen, the exploration and production companies that are growing the natural gas volumes and oil volumes as a group, aren’t actually seeing the benefits. 

Three things are taking place and are the three causes of that surprise. One is that the growth in production, both for natural gas and oil, has taken place quicker than the ability of the industry to move that product out of the local market. As a result, for natural gas we’re seeing U.S. natural gas prices traded at a discount to global markets. 

For oil, the oil production growth that’s taken place has resulted in U.S. onshore oil prices trading at a significant discount to global oil prices. Now, in both cases, that’s more of a transportation-bottleneck issue that eventually will be fixed, but it has not been fixed yet. So from an income statement point of view, when I look at the group, they’ve delivered on the volume growth, [but] this has been offset by pricing. 

It’s also been offset by rising costs. While it’s possible to grow oil and natural gas production in the United States, the cost per unit has in general been skyrocketing upwards. This holds truer for oil than for natural gas. 

Natural gas costs have basically stabilized over the past couple of years and in some cases have come down. But for oil, the development costs and the operating costs have been trending continuously higher, almost regardless of what’s been taking place with the service pricing. 

The resource that these companies are developing is a higher-cost resource. So if or when you start to see oil service pricing come lower, the fact that the companies are producing from more expensive zones has been driving up per unit costs. 

The third [issue] is it hasn’t really been a group call. One surprise has been that the E&P group as a whole hasn’t outperformed in the face of substantial volume growth. That’s true for the group, but it’s not true across the group: There’s been a wide dispersion of performance across the group. Some companies have done a much better job managing costs. Some companies have done a much better job delivering the volume growth. So, it varies. 

It’s a company-by-company situation where some of the companies have done very, very well. One of the best-performing stocks, I think, the best-performing stock in the S&P 500 over the 2011-2012 time period was a U.S. natural gas producer. Natural gas prices went down over that timeframe, but I believe that the best-performing stock was a natural gas producer. They drove costs lower. They delivered on the volume growth. They were the company that successfully implemented the disruptive technology that pushed down natural gas prices. Their stock did benefit, but a lot of their competitors did not.

Riley: As a broad generalization, the U.S. natural gas price was weaker than we expected 18 months ago; the Brent oil price was stronger; West Texas Intermediate (WTI) and the prices available for Bakken and Permian basin oil were in line with our expectations, and natural gas liquids (NGLs) were weaker than we expected. These more or less fed through into the actual performances we saw. 

Thus we were not surprised by the weak performance of the gassier stocks on the back of the extreme weakness of the U.S. gas price last March. And mostly the winners were the stocks in the right (i.e., oily) basins with good execution.

What energy trends are driving the E&P sector’s business results and its business strategies—and why?

Coleman: The most notable trend the past couple of years has been the targeted drilling of oil and liquids plays. Oil prices have remained very favorable relative to natural gas prices, so companies have been aggressively repositioning their portfolios to take advantage of that pricing outlook. 

The North Dakota Bakken oil play has been the biggest beneficiary, with other plays such as the Eagle Ford and Niobrara gaining traction, too. But the growth in liquids coming from natural gas plays swamped infrastructure, leading to a pullback in NGL pricing. Combined with decade low natural gas prices, the entire gas value chain remains challenged.

Dowd: The energy trends are basically the ability of the companies to evacuate their product and get global market pricing, the ability of companies to control costs or reduce costs and the ability of the companies to effectively implement strategies that will enable them to profitably grow volumes. But it’s, again, the same themes. 

You can make the case that we’ve seen a disruptive technology enter the energy space. Horizontal drilling and fracturing is enabling the development of unconventional oil and unconventional natural gas resources; from an aggregate point of view, this is a big deal. 

This is important in that it enables the overall U.S. energy sector to grow volumes. The U.S. is one of only a handful of countries in the world that has grown oil production over the past several years. Most of the resource based outside of the U.S. is also seeing costs inflation and is seeing production decline. So, when you look at non-OPEC countries outside of North America over the past several years, the production has actually declined. 

The theme that’s driving the stocks is going to be the ability of these different companies to execute on their business plan. That means are they going to be able to successfully implement the technology, this disruptive unconventional oil and gas drilling technology, and use it to drive profitability higher?

Forman: We believe that the U.S. is in the early stages of a long-term trend to re-emerge as a global leader in both oil and natural gas production. This month, the Energy Information Association reported that oil production topped 7 million barrels per day (mbpd), which is up from a recent low of about 4 mbpd. Although it represents a 20-year high, it is well short of the approximately 10 mbpd produced back in the late 1970s. Advancements in technology, specifically hydraulic fracturing and horizontal drilling, are primarily propelling this resurgence. 

Areas of the nation that were once nearly nonexistent from a production standpoint are now among the leaders in production. Last year North Dakota overtook Alaska to be the second-largest oil producing state in the nation. Given the movement afoot, there has been a strong demand for capital as the nation builds out and, in some cases, replaces its infrastructure and extracts resources from the ground.

Tim Guinness, Guinness-Atkinson: The big-picture driver for energy markets that is too much ignored by commentators is the demand shock from the emerging world that is near doubling the world’s vehicle fleet from 1 billion to 1.8 billion vehicles from 2010 to 2030 and increasing miles flown by a similar margin. 

We see global demand for oil growing by at least 10 million to 12 million barrels/day by 2020 and compared to that the extra U.S. oil supply from shale oil (2 million barrels per day say) is not a game changer. Nor will any rise in LNG or electric vehicles remotely dent this. 

Outside the U.S., non-OPEC supply from places like Brazil, Africa and the Caspian region struggles to grow enough to replace declines from mature field in e.g., the North Sea and Mexico. All of this, plus OPEC’s position as successor price-setter to the Texas Railroad Commission, will keep oil prices firm. 

Our projection is that oil prices will rise from, say, $100 today in line with global GDP growth in nominal terms (i.e., at circa 3% (real growth) plus 2% per annum inflation equals 5%per annum). On this basis, oil prices will average $148 per barrel in 2020.

What potential upside do you see for the E&P sector for the next six, 12 or 18 months, and why?

Coleman: Through 2013, we continue to watch for signs that all the supply growth the industry has delivered will find accessible markets. With lower interest rates, we’ve seen a bit more debt issuance, continued interest in asset monetizations to close company cash flow gaps, and a lower level of new equity infusion. Our concern over the timing of supply/demand balancing led us to be bearish on oil prices about the middle of last year, and we have maintained that stance. 

In the short term, we’re pretty focused on the potential for oil and natural gas inventories to outpace demand, offset by continued political tension in the Middle East, and quantitative easing around the globe medium term.

Dowd: I focus more on trying to differentiate the stocks within the sector than making a macro call for the group. I think that from a practical point of view over the next six, 12 or 18 months, the group as a whole is going to be driven by natural gas prices and oil prices. And I don’t have conviction on what the global economy is going to do over the next two years. So, I really don’t have conviction on what the trend in oil prices is going to be. 

That being said, if a company is successful at maintaining its cost structure and growing its volumes 20 to 30% per year organically, I would expect its stock to appreciate 20 to 30% per year. Now, that’s the success case. 

The good companies in the sector should be able to deliver that type of results. The weaker companies in the sector are going to be delivering sometimes negative or up to 5 to 10% volume growth coupled with rising costs such that the earnings actually decline. But, I’m assuming a stable flat commodity price outlook, and I’m trying to figure out which companies are best positioned to execute in that environment.

Forman, Franklin Square: It is our view that the energy renaissance in the U.S. is still in the early innings of a game that could possibly go into extra innings. The E&P sector should continue to benefit from this movement as more companies seek to extract resources from the ground. Additional advancements in technology could further propel the ability to squeeze more reserves from each well, increasing the possibility that the U.S. becomes energy independent.

Guinness: The next 18 months will be a period of rising oil prices for U.S. oil (as the discount to Brent narrows bringing WTI up to $100) and for U.S. natural gas (as supply and demand come back into balance at the long-run marginal cost of the marginal shale million cubic feet, or mcf, which we believe to be nearer $5 than $3.50/mcf and certainly over $4). Brent will remain solidly firm. 

This backdrop will enable investor confidence, which was knocked by the natural gas price bust last year and was unnerved by Libya coming back on stream and fears of Grexit (the Greece Euro-area exit) and China’s hard landing, to recover. We see steady growth in E&P results from here leading to useful outperformance against the broader market with some enterprise value/earnings before interest, taxes, depreciation and amortization (or EV/EBITDA) margin expansion occurring.

How do you expect the E&P sector to perform in the intermediate- and long-term?

Coleman: Given our cautious/bearish commodity outlook, we have no “strong buy” rated names in our coverage and so until we get more clarity on the balancing of supply/demand fundamentals, we do not anticipate a meaningful amount of upside the sector. 

Once the market has a chance to balance, we see the medium-term outlook for stocks to be a lot better than the short term. I generally prefer larger-cap, defensive names, especially on the gas side of things. On the oil side, even though oil prices may soften, the commodity is more robust than gas so I’m a fan of higher growth, top-tier acreage holders in places like the Bakken.

Dowd: I don’t really believe it’s a group call. Clearly in any given day, the whole group moves up or down together. But over the intermediate and long term or even over the next two years, I think that some companies are positioned to deliver earnings growth, and some companies are more challenged. 

Over the past several years, we’ve seen a land grab take place where companies in the exploration and production space have leased up millions of acres of land across the United States and Canada, and they’ve leased these lands in anticipation of being able to apply these new technologies economically to the resources that lie underneath these lands. 

For several years a substantial portion of the cash generated from these companies was being reinvested in securing these lands. They would pay lease bonuses to the landowners. They would basically acquire these lands from either the owners or from other groups that aggregated them. This was a major investment on the part of the industry. 

I think the land grab is coming to an end, and what that means is there are some companies that have won and have secured solid perspective positions that will be harvested for years to come. There are others that are still struggling, because they have not secured that land position, and they’re going to continue to be investing aggressively in order to solidify their future. 

So, there’s a big different between the haves and the have-nots within the industry, and I think that the differences across the group are large relative to the outlook for the group as a whole.

Forman: Intermediate and long-term trends are more difficult to forecast given the potential for new technologies and new discoveries. Even with the expected strong growth in the sector, companies will still require capital to maintain, expand and/or grow their businesses. We feel comfortable that lending to energy-related companies will continue to provide attractive investment opportunities.

Guinness: In the U.S., horizontal drilling and fracking are enabling the production of both oil and natural gas from oil and gas shales to occur profitably and grow, when the oil price is over $70 and the gas price is over $5. Naturally the E&P sector in the U.S. is energetically pursuing the lowest cost areas for this—Bakken (for oil), Eagle Ford (for oil and gas), Marcellus for gas, and Permian (for oil). 

Outside the United States, exploration/development progress is being achieved around Africa’s shores, in Colombia, offshore Brazil and in selected parts of Asia—Vietnam, Malaysia, Thailand and (for natural gas) Australia. 

Essentially the private sector is stepping up to the plate and supplying the extra oil needed by the world, while OPEC and Russia and other national oil companies will not contribute much to this. So to the steady growth in profits as prices steadily appreciate over time, we can add—for probably the whole of the next decade—rather higher production growth for the independent oil & gas sector than seen in the 1980–2010 era.

 

What potential risks should E&P-sector investors monitor? For example, are there any potential regulatory developments in the U.S. that might affect your outlook?

Coleman: E&Ps, by their very “growth-oriented” nature, hold investor allure when production growth drives top-line expansion and economies of scale keep operating costs in check. Our net asset value models help us determine which companies are successfully capturing the most resources. When companies trade below the value of their proved reserves, then we expect to see some merger & acquisition activity close those gaps as well (e.g. the “make versus buy” argument). 

Primary risks to the sector involve: one, commodity price risk and, two, political risk, especially in the Middle East. Additionally, since the industry has done a masterful job of innovating and unlocking previously unexploitable shale resources, the industry faces the prospect of “drilling their way to lower commodity prices.” 

But, with greater supply certainty, especially in the U.S., the less dependent we are on imported resources and the more jobs will be created here at home. The risk from continued success is that the industry needs to spend more time educating constituents on the benefits of the activity that is now occurring in places that prior to the shale boom hadn’t seen the oil industry in decades.

Dowd: There are many. I think there are economic risks to the extent that the global economy slows or to the extent the Chinese economic development slows. That would be a negative for the commodity price, and that would present a headwind to the overall group’s performance that we haven’t really been talking about. 

For companies that operate outside of the U.S. or even for companies that operate within the U.S., there’s always the risk of terrorist attacks or political change or changes in the tax regime that would impair the profitability of the group. 

Most countries around the world have been increasing tax rates on energy production, and I don’t think the U.S. is immune from that trend. So that’s a risk. 

There’s potential for environmental legislation. We could see more stringent regulation of the hydraulic fracturing business that has enabled this growth in supply. That industry could be regulated in a way that would materially change the cost structure and impede activity, which would be a negative. 

We’ve seen shortages of services emerge periodically, which have impaired the ability of the E&P industry to execute. 

When I look at it in the aggregate, I’m fairly optimistic on the outlook for certain companies. I’m fairly optimistic about the outlook for the companies that have secured sizable land positions in geologically advantaged areas.  

At the end of the day, this business is driven by the economics, and the economics of developing natural gas or the economics of delivering oil for the marginal companies today are not attractive. So I don’t think that we’re starting from a point where drilling economics for mediocre companies are great. 

We’re starting from a point where the drilling economics for the mediocre companies are actually abysmal, and most of the companies in the space are earning rates of return or return on assets. Many of the companies are delivering today return on assets below 5%. 

So, this isn’t an industry that is currently frothy from a return point of view, and as a result the valuations are not stretched for the group as a whole. I think that mitigates a lot of the economic risk going forward. There’s always the potential for disruptions or outages caused either by terrorist attacks or by just operational challenges. But, for a portfolio that holds different names, I think we can manage through that type of volatility.

Forman: We believe that U.S. oil and natural gas companies are in a favorable position to expeditiously harvest many of our conventional and unconventional resources. The ability to buy and sell mineral rights, leverage the extensive network of pipelines and satisfy the abundant demand for our resources all bode well for the upstream sub-sector. The sub-sector is, however, not without risk. 

Regulatory risks will always be present in the space and any governmental action to curtail production could impede a company’s ability to succeed. Vital to our ability to extract resources from shale formations is hydraulic fracturing. If the government suspends or limits the use of this technology, it could have negative consequences on the ability of the U.S. to achieve energy independence. 

We feel that E&P investors should continue to monitor political developments that could impose additional regulations on both the federal and state level. The energy space is heavily regulated, and current regulations have tended to favor natural gas production at the expense of coal. This move has caused many coal-fired power plants to switch over to natural gas, providing weaker demand for financing of coal-related projects.

Guinness: Short-term energy prices are volatile. The short-term price elasticity of demand is low, so small shortages or surpluses can cause wide price fluctuations. This comes with the territory. 

Sensible investors must look through this volatility to the average prices that are achieved by medium-term supply/demand factors. Again, political turmoil is ever present. Think the 1974 OPEC embargo … Will Al-Qaeda close down Algeria, Libia or Egypt? 

All of these are very real factors that may disturb the short run price deck (and so profits). But we’ve been here so many times before, and we know in the long run they are noise. 

The world at the moment is facing an upsurge in demand for oil and gas, because three billion people are energetically moving towards achieving a 50% of OECD gross domestic product per capita with all that means for energy consumption. This is a good investment space for the value investor with a medium/long term investment time horizon. It’s cheap on historic metrics (in our opinion); it’s an inflation hedge; and it will grow value long term.

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