Oil Equities - Industry Analysis

Disclaimer: Nothing on this post or blog is investing or financial advice; please see full disclaimer here.

INTRODUCTION

Objective of this post is to provide a quick, dirty industry investment framework (from a generalist perspective) to understand key drivers for the North American Oil E&P  (explorers and producers) sector.

Background/Brief History

Production of Oil currently dominated by US, Russia, and OPEC (cartel of primarily oil-rich middle eastern and African Nations). OPEC holds meaningful influence over oil markets (~40% m/s in production), setting production targets as a group which then have a flow-on effect to Oil prices (i.e., curbing production will move Oil prices up vice versa).

Figure 1

2002 – 2008

Surging global demand, with slow supply growth and limited spare capacity set the concoction for a raging Oil bull market. A large contributor to the demand was the growing energy needs from emergence of China and India.

2008-2009

The GFC stopped the party.

2010 - 2014

Demand Recovery post GFC, and some supply side shocks from Geopolitical events fueled (yes pun intended) the next ~$100 Oil cycle. Civil war in Libya, sanctions on Iran crippled supply by almost a peak of 3.5 million barrels per day.

Figure 2

2014 – 2019

Supply glut -> Geopolitical supply issues subsided and coincided with broad realisation that US would become a major supplier alongside OPEC.  US had mastered technology (Hydraulic fracking) to economically extract Oil from its abundant shale formations. And boy did the shale players drill like no tomorrow, flooding the market with Oil; USA became a net exporter of oil over this period and more than doubled their production since start of 2010s. E&P companies were notoriously aggressive in drilling, despite falling Oil prices stretching their B/S’s and broadly engaging in S/H destroying value (Figure 1 conveying the poor performance of XLE from 2014 onwards).

2020

COVID severely dampened Oil Demand sending prices tumbling beginning of Q1. Additionally, Russia didn’t agree to OPECs plan to curb supply amidst weakening demand environment triggering a price war between the two groups that sent Oil prices crashing. Eventually both groups agreed to curb supply.

2021

Oil Demand from COVID disruptions recovered quicker than expected and supply was unable to keep up pace, setting the stage for a strong Oil rally.  Data points on the supply side indicated tightening conditions; US shale producers promised capital discipline and a focus on S/H returns instead of drilling, several European Oil Majors diverted CAPEX to ESG initiatives (renewables over drilling) and OPEC disappointed on production.

Figure 3

2022

History doesn’t repeat itself, but it rhymes. Once again, we find ourselves in a geopolitically driven supply shock driven by Ukraine-Russia war, and subsequent sanctions on Russian Oil sales.

Industry Drivers

The macro environment around supply/demand dynamics remains the most crucial driver for Oil prices in my view, and hence returns from Oil equities (a rising tide lifts all boats). The micro or the bottom-up is secondary;  quality of assets, shareholder return propositions, valuation etc.  Therefore, as a generalist I play oil equities via first having a view on macro direction, i.e., is supply tight, is the outlook to normalisation opaque and are prices trending higher (much like today)? If yes, my process would then be to focus on the highest quality Oil equities to limit any curveball idiosyncratic risks that can get in the way of returns.

The Macro

Supply

The focus on Macro should be the supply side during steady-state environments. Recent history (see background section) indicates the dynamics on the supply side have been key cycle determinants, i.e., tightening supply (Figure 4 indicates geopolitics has been a recurring factor in supply shocks and subsequent oil price rallies) or a supply glut (US shale cycle from 2014s).

Figure 4

Inventories and Spare Capacity

Supply side is best tracked through Oil inventories/spare capacity data (EIA website); periods when production is underperforming demand, inventory levels are usually lower (as these sources are tapped into) than historic levels as depicted in Figure 5. While below refers to US, much of the inventory picture extends on a global level. OPEC spare capacity has also disappointed expectations and may continue to do so, Fund Manager Bison Interests providing excellent colour on this issue in their “The Myth of OPEC+ Spare Capacity” article.

Figure 5

LT Supply side considerations

While theoretically supply should rise to meet demand, this is hard to gauge in the current Oil Bull run because of three key points:

Point 1: US (largest producer of oil) E&P companies are on a “leash”, executive incentives are focused on returning capital back to S/H, paying down debt and remaining disciplined (i.e., limited production growth).

Figure 6

Point 2: ESG and quest for sustainability is also putting pressure on CAPEX for further production growth. European Oil Majors (Exxon, BP, Shell) pivoting to renewables and energy transition.

Figure 7

Point 3: OPEC unlikely to be “knight in shining armour”. Spare capacity has disappointed (read above), and history (2000s oil bull market) would indicate they have been happy to sit tight and let prices run instead of an aggressive supply response to balance the market.

Demand

In a steady state environment, my view is to place less focus on demand except for the general direction (focus more on supply dynamics as discussed above). Directionally, demand for Oil is expected to be in growth mode for the foreseeable future as summarised in Figure 8 from forecasts provided by IEA and EIA. The caveat to this, is if there are tail risk events such as a global recession.

Figure 8

The Micro

Asset Quality

Superior assets in my view are those with low decline rates, limited maintenance CAPEX. Companies with these assets tend to have better C/F profiles, B/S’s and can sustain production over the next decade without additional CAPEX. Across North America, there are two main types of Oil deposits: Canadian Oil Sands and US Shale. The former is far more superior in my view; while initial CAPEX costs are higher (not really an issue if assets are mature and beyond greenfield stage), decline rates are significantly lower. $CNQ (Canadian Natural Resources) a notable Canadian oil sands operator quotes Reserve Life Index of 27+ years.  US shale on the other hand, requires less up-front costs but accompanied by higher decline rates meaning players continue drilling (higher maintenance CAPEX) to maintain production levels. Figure 10 by Hart Energy conveys first-year declines of ~34%.

Figure 9

Break-even prices

Essentially the price of Oil below which E&P’s start to become negative FCF, after deducting maintenance CAPEX and DPS. The lower the break-even price for an E&P the more “margin of safety” it can afford when oil prices are declining. Prices of low to mid ~$30- $35/bbl. is considered top tier.

Figure 10

B/S Strength and Shareholder Returns

Negative sentiment towards fossil fuels, has raised questions on terminal value risk, underperformance of the E&Ps pre-COVID also did not help their case (especially from 2015-2019). The market in the current environment prefers to own E&P’s that are increasing dividends and buybacks over production growth and growth CAPEX.

Figure 11

VALUATION/UNIT ECONOMICS

Generally, to track valuation for sector I focus on FCF Yield and EV/EBITDA over FY1 – FY3. When looking at individual Co.'s, usually combine this with a mini DCF valuation over 3-5 years of C/F’s, apply a conservative exit multiple around EV/EBITDA of ~4.0x with a WACC of ~10%. I tend to avoid NAV’s; US companies usually disclose these based on SEC requirements but there are numerous assumptions around costs and estimates that are NPV’ed beyond a reasonably forecastable time horizon.

Asset Based Valuation (NAV)

Oil and Gas Co.'s in the US disclose PV-10; essentially the present value of revenues less costs expected from “proven reserves” applying a WACC of ~10%. “Proven Reserves” can be ambiguous and to my understanding can include estimates around reserves that aren’t producing.

Multiples

Relative to S&P 500

XOP (Oil and Gas E&P ETF) discount to SPY indicates O&G amongst cheapest levels since 2007. +30% re-rating would imply discount in-line with historical levels.

Figure 12

Figure 13

DCF

Revenue = Price (Price of Commodity) x Volume (Production)

· One way to select price, is to look at forward curves for the next 2-3 years and use that as a base case input. Figure 17 is for illustration purposes and for simplicity we have just left prices constant.

· E&P companies usually give guidance for production growth, if opaque I’d consider looking at historical production growth and using that as a guide. You can add layers to this analysis, by studying the respective basin of focus, decline rates etc.

· The beauty about modelling, is one can run numerous sensitivities (Price and production) to settle on what is reasonable based on industry datapoints, company fundamentals etc.

Figure 14

Costs = Transportation & Processing + Production Costs (includes Production Taxes, Lease Operating Costs) + SG&A + DD&A (Depreciation, Depletion & Amortisation)

· Given variable nature of costs, prefer modelling costs based on per unit volume basis. Note the costs per unit of volume are not standard for the industry and can vary company to company. The best way to derive forecasts is to utilise company guidance, earnings calls or company investor presentations.

· Unit economics are best summarised by breakeven analysis -> companies with best unit economics have lower breakeven prices (see Figure 10)

Figure 15

Figure 16

Figure 17

Data/Tracking sector

Rig count data: https://rigcount.bakerhughes.com/intl-rig-count. Rigs are machines used for drilling Oil and Gas. Tracking rig counts, provides some clarity on supply response (i.e., higher rigs can be an indication that additional supply may come into market).

As we can see below rigs are trending higher, but on an international scale still below pre-COVID levels with demand almost recovering already to pre-COVID levels.

Figure 18

EIA Short-term Energy Outlook: https://www.eia.gov/outlooks/steo/pdf/steo_full.pdf Good details and forecasts around US Oil/Gas demand, supply, and inventories.