In our last commentary (“Energy Markets: There Will be Winners and Losers”), we gave our current thoughts on long-term US oil production and the vulnerable sub-sectors within the energy industry. So far this year, US production has been resilient even with rig counts falling over 50% from their highs and capex budgets being slashed. The “fraclog” (wells that have been drilled but not completed) has played a big factor in this, both psychologically and fundamentally. In addition to the “fraclog,” hedging has played an important role in the resiliency of production. Many producers have a large percentage of production hedged forward at higher price points than what oil is selling for on the spot market today, allowing producers to keep drilling to replace production and reserves in anticipation of more bank line revaluations in the fall (meaning they want to keep up production/reserves so that those bank lines are not reduced). This is unsustainable in the longer term, but for the time-being has led to solid top line numbers at a time when costs are coming down, leading to robust margins. Every company’s hedging policy differs, but the bulk of these high priced hedges will start to roll off at the end of Q2 and the reality of today’s lower oil prices should start to show up in the numbers towards the end of the year. It may take a couple more quarters to see US production start to decline, but it is inevitable.
A WTI (West Texas Intermediate) price around $60 could incentivize companies to keep hedging as lower costs make some plays more economically viable. Lower costs are leading to increased IRR’s on INDIVIDUAL wells, which is helping to keep the capital markets open in some cases. We would urge investors to take a deeper look into what these IRR’s mean for the company as a whole. While individual well economics may be decent, investors need to take into consideration some of the real capital investment necessary that does not get factored into these returns. This includes capital expenditures such as facilities, land, pipelines and other related infrastructure and processing facilities required to maintain the business. In the trade we call these “full cycle costs.” When factoring all true costs in, returns at the corporate level are much lower than the returns shown via many investor presentations we have seen. Our friends at Bank of Montreal (“BMO”) appear to be on the mark1: Disconnect Between Play IRRs and Corporate ROCE (return on capital employed). Many companies advertise IRRs at a play level of more than 50% but deliver returns at a corporate level well below 10%…The return on capital employed (ROCE) in the oil and gas industry has steadily declined since 2007 despite relatively strong crude oil prices. In 2014, the worldwide ROCE fell to the lowest level in the history of our annual Global Oil and Gas Cost Study database at only ~7%. This implies that most companies, particularly pure upstream producers, are already not making returns on invested capital at $100/bbl oil let alone $60/bbl oil.
While we should never be surprised at the ingenuity of oil and gas management teams and their spin to a relatively uninformed investor base, the massive influx of both debt and equity capital so far this year into certain areas of the energy sector is nothing short of shocking. We’ve seen reports that energy equity issuance is running at multi-decade highs so far this year, and that high grade energy debt levels are now at 15-year highs, as issuance has remained strong this year. We certainly could not have guessed this would happen, but of course that is what makes markets interesting.
Our energy exposure remains extremely focused. As stated many times before, we continue to favor Canadian heavy oil producers, which have and should continue to benefit from tighter spreads and a decreasing Canadian dollar. In fact, the Canadian heavy oil producers are receiving prices that are not that far off from their highs based on these two factors. On the other hand, US shale production, while impressive for now, is still not something we see as an industry, but a series of shorter-term projects that should not be financed with long term debt. As we have noted in past writings, we are still seeing reported decline curves of about 65-70% for these wells in the first year, regardless of what prices are being received for the final production. Again (as noted in our commentary, “Energy Markets: There Will be Winners and Losers” and “Irrational Oil Markets”), we have our concerns about the long-term liability of this sector.
While we have been painted with the oil bull brush, we are currently underweight the industry relative to the broader high yield market indexes and many of the passive funds that track these indexes. This is all about valuation for us. In our opinion many energy related bond and loan prices are way ahead of their true fundamentals and are not compensating us for the level of volatility we expect going forward and lack of a sustainable business model in many cases. During this run, we have taken off our energy services names as we feel that pricing pressure for these businesses will get more intense as the year progresses. Our opinion has not changed, as we expect continued volatility in energy prices going forward, as well as volatility in the underlying fundamentals of many companies in the space as hedges roll off and production is inevitably curtailed.
1 Ollenberger, Randy, and Jared Dziuba, CFA, “Back to Basics: Returns Matter,” BMO Capital Markets, Oil & Gas: E&P, May 26, 2015, p. 1, 2.
This article was written by Tyler Gramatovich, Research Analyst for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD.