Written by an ex-bulge bracket oil & gas investment banker
Recent History of Oil & Gas Stocks
US shale players, so hot before 2014 and trading at tech multiples under a growth at any cost scenario, have peeled back tremendously.
Shale and other unconventional forms of oil extraction had seen huge breakthroughs in technology in the last decade, leading to a flood of US oil hitting the market. Revenue for oil and gas firms is a function of price and volume (production). Production was growing rapidly and therefore revenues and cash flows jumped as well.
Oil and gas trading multiples such as EV/EBITDA, EV/DACF, EV/EBITDAX, EV/Production all rose in anticipation of rising production, prices and cash flows. Healthy companies traded at 40-200x price/earnings while more speculative companies did not have earnings or cash flow but had large premiums on their production.
Oil and gas prices were strong and a barrel of WTI went to $120 when ISIS closed in on Baghdad. Military sources did not feel that Baghdad’s defenses would be breached, but the market in its euphoric state kept boosting an already large risk premium on oil. The reality was that supply was plentiful and demand was stagnant. Inventory stockpiles were rising and the market and Wall Street convinced themselves and everyone else that OPEC would cut production to keep oil prices high. This ended up being bad advice – OPEC had no incentive to give up market share to US shale and announced that they were maintaining production. Oil prices plummeted, hitting a trough below $30/bbl of WTI.
Oil and gas exploration and production companies piled on to fund their drilling programs with debt issuance (high yield bonds, which generated plenty of fees for the energy coverage and leveraged finance divisions of investment banks), thinking that their EBITDA would grow into the debt to de-lever. The reality was that in order to maintain production, especially given the large decline profile that shale oil has, more money had to be thrown back into the ground through capital expenditures.
This means no money to de-lever as all EBITDA is actually spent used for reinvestment.
Large acquisitions were funded with bond issuances at the peak of pricing. Many deals transacted while a barrel of oil was $120 (West Texas Intermediate) – leading to excellent exits for private equity firms.
Pullback in US Shale Oil Stocks (2014 and Ongoing)
When oil prices crashed in 2014, many of these indebted companies could not meet their debt obligations. Companies went into financial distress and required restructuring.
The initial wave of restructurings were a band-aid on an unsolved problem. Noteholders agreed to amending indentures for escalating interest rates or equity issuance – basically kicking the can down the road for companies that would inevitably be insolvent. Certain firms were too levered and had to undergo full restructurings then and undertake distressed M&A. Many companies entered into Chapter 11 bankruptcy.
While the S&P 500 continued to break new records year after year, energy languished. Today, energy is a far smaller constituent in the broader market index than where it was at the peak of Big Oil.
Oil & Gas Stocks in 2020
Oil and gas stock multiples are at all time lows due to investor pessimism and an inability to generate returns for shareholders.
Accordingly, company management and the investment bankers that advise them are now making changes to corporate strategy. Instead of growing production, the focus is on cutting costs and returning capital to shareholders.
Oil & Gas Focus on Capital Discipline and ROCE
Capex programs are being pared back – especially discretionary capital expenditures, with management setting up a plan A, plan B and plan C for spending which depends on the underlying oil price. Remember, oil and gas companies sell an undifferentiated product and are price takers not price makers.
Investors are looking for capital discipline and investment only when the returns are right. On a project basis, companies will look at IRR and NPV. From a corporate basis, investors are looking to see acceptable return on capital employed (ROCE).
Now, investor presentations will commonly show operating cash flows (or funds from operations or whatever metric they feel is appropriate) and capex under each oil price scenario. For instance, there may be a bluesky case with $70 WTI where spending ramps up, a base case with $60 WTI where production is flat, and a $50 WTI case where they live within their means.
It is important to remember that oil is a finite resource and a non-renewable resource. As such, there is a limited inventory of oil in the ground that must be replaced by discovery or acquisition. As such, a high decline rate of the inventory means that resources need to be replenished more quickly in order to preserve the future value of the company’s cash flows.
There is also a big focus on decreasing costs in order to improve margins. Oil and gas companies will put pressure on oilfield services firms to reduce costs. Also, through scaling operations and production, the cost per barrel improves as lease operating expenses are spread out and operating netbacks improve. Drilling longer laterals and achieving economies of scale for sand, pressure pumping horsepower, water infrastructure are also helpful for lowering costs per barrel of production.
G&A costs in head offices are also being pared back as costs are slashed and headcount is reduced. Companies have to adjust to this new normal in the oil and gas sector and the ones that do not are shunned by investors or go belly up.
Mergers and Acquisitions in Oil and Gas in 2020
A great way to achieve economies of scale is through consolidation.
Buy side investors are not interested in small oil and gas companies, and as such they trade at much lower multiples than larger players such as Apache and also receive very limited equity research coverage – a vicious cycle. These may be private companies with a decent production base – but increasingly companies are finding that they need to have production close to 100,000 barrels of oil equivalent per day to stay relevant to a Fidelity or Prudential.
Acquisition can be at a very small scale. In oil and gas investor presentations, corporates may refer to this as a “tuck-in acquisition” or “bolt-on acquisition”. This can be as simple as purchasing contiguous land or doing equity swaps with adjacent operators. If the engineers and geologists are savvy, this can be a great way to improve ROCE as acreage acquisition costs are low but the drilling results are good.
Acquisition, increasingly done through an all stock transaction because the market does not want to see more debt on E&P companies, is also a good way to merge with a competitor and realize proximity synergies. Two adjacent operators have a ton of shared costs that can be removed and myriad scaling opportunities. We are seeing this in the oil patch all the time now, especially in the Permian Basin.
Thinking around capital structure has also changed. Although oil and gas has always been a volatile industry with less appetite in the market for oil & gas LBOs, 3x Debt/EBITDA used to be considered levered. In today’s depressed environment, 1.5x EBITDA is considered levered. Banks will also have a tighter leash on oil and gas corporates and may require mandatory hedging (conducted through their sales and trading divisions of course) to secure cash flows.