Moving Ahead

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.