Value Investing In The Oil Patch: A Loser's Game

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Includes: CVE, IMO, UNG, USO
by: David Addison

Summary

Cash-based industry operating metrics strongly indicate that U.S. publicly traded energy companies have pumped more cash into the ground than they have recovered (and likely may ever recover).

The data on endemically declining returns on upstream investment are consistent with economic theories regarding energetic measures of return and resource quality.

Given these observations, I believe the investment value of many oil & gas producers is a function of "residual" value leftover from previous capital investment.

However, implementing this approach is problematic: upstream producers tend to be overcapitalized (e.g., stock prices discount higher commodity prices; many will never become cash flow-positive).

While there may be room for speculation, I argue that generalist investors should pass on the oil patch altogether.

Overview

Value investing in the oil patch feels a lot like dumpster diving lately. Cash-based industry operating metrics strongly indicate that over the last decade, U.S. publicly traded energy companies have pumped more cash into the ground than they have recovered. While cash-based return metrics fail to account for the value of future cash flows based on previous investment, it is evident that broad swaths of the oil & gas business will never likely recuperate sunk costs. This phenomenon is perhaps most evident in the shale patch. In a recent article, Zoltan Ban documents that collective investment into the Eagle Ford since 2010 exceeded cumulative net revenues by about $44-64 billion. Converging evidence from the Independent Petroleum Association of America (IPAA) confirms "that independent producers are investing 150 percent of their domestic cash flow back into domestic oil and natural gas development".

Endemic cash flow deficits result from investors' willingness to infuse marginal production with new investment capital. This behavior, which is in turn a likely result of very low interest rates, underlies this market sector's relative over-capitalization, stock price resilience, and even the global supply "glut". Generally, throughout the present commodities cycle, low interests have supported the production of marginal resources and suppressed (distorted?) market mechanisms for rational rebalancing.

My prognosis is that the entire oil patch may be likened to a giant ashtray filled with Ben Graham-esque cigar butts. Within the butt pile, there may be a good few puffs left on a few stocks. There may even be some stocks which have been carelessly discarded. Indeed, though this industry may have already its zenith, there may be years to decades left to ride out the occasional bargain. But that's precisely the key distinction between this and other industries: true valuing investing in this space is almost never a narrative on long-term value creation, nor even sustainable asset replacement. Rather, it is most often a matter of locating and profiting from terminal value leftover by previous (mal-)investment capital. In this less-than-zero sum game, I believe that individual stock picking is best left to professional speculators, but I also certainly would not recommend any broader industry indices to the generalist investor.

Industry Cash Flows Paint a Terminal Narrative

I appreciate the inherent difficulty in supporting the broad claim that reservoir replacement is not profitable. The timing offset, whereby cash is sunk into the ground well before it is returned, makes simple accounting comparisons problematic. However, cash flow measures are audited and are representative of full-cycle economics, unlike well-/field-/play-level economic measures such as net asset value (NAV) and discounted net present value (NPV) which are typically seen within investor presentations and third-party research. Moreover, unlike GAAP income, it is problematic to subvert cash flow accounting to distort short-term metrics, because corporate-levels cash flows must fit into one of only three buckets which represent sources and uses: operations, investments, and financing. To the extent that reported net cash flows do not give accurate representations of the business is due to error, perturbations in currency exchange rates, or fraud.

I submit that the "Funds Flow Adequacy Ratio" (FFAR) is an advantageous measure of resource efficiency, because if net cash outflows exhaust cash hoards, cash flows from investment capital must cover the shortfall. While cash flow deficits can be sustained through infusions of new investor money, investors will eventually demand a return lest they withdraw their interests. Furthermore, the fact that the current supply "glut" is measured in numbers of days indicates that oil companies' reserve and production growth has not far outstripped the rate of demand growth (i.e., historical cash flow outlays roughly approximate maintenance capital expenditures). FFAR is defined thus:

FFAR is synonymous with cash flow return on investment (CFROI). It is essentially a GAAP equivalent of the industry standard recycle ratio. Note that interest expense appears twice in FFAR to compensate for the fact that GAAP accounting practices typically include it as an operating cash flow. While capitalized interest can indeed be considered an operating expense, financial interest (which form the bulk of interest expenses) are logically much more closely related to financing activities, much like a dividend.

Table 1: Aggregate Funds Flow Adequacies of U.S. Publicly Traded Energy Companies over the Past Decade: 2007-2016

Subindustry Global Industrial Classification Standard (GICS) Code Market Cap (US$, MM) Companies in Sample 10-Year Funds Flow Adequacy
Oil & Gas Drilling 10101010 26,031 20 0.861
Oil & Gas Equipment & Services 10101020 265,042 85 1.016
Integrated Oil & Gas 10102010 1,676,658 20 0.985
Oil & Gas Exploration & Production 10102020 562,571 188 0.850
Oil & Gas Refining & Marketing 10102030 151,245 36 0.968
Oil & Gas Storage & Transportation 10102040 607,739 105 0.532
Total 1010 (excl. 10102050) 3,289,285 454 0.894

(Source: Portfolio123; Author's calculations)

Note to Table 1: "Energy" Subindustry metrics have been aggregated according to companies' MSCI/S&P Global Industry Classification Standard (GICS) code. The "total" row excludes "Coal & Consumable Fuels".

It is notable that the entire oil & gas industry has returned less than $.90 on every dollar invested over the past decade. Only the service subindustry has managed to accrue cash flows in excess of capital investment. It is also quite significant that the storage and transportation industry (i.e., pipeline companies) has been great a sinkhole for investor money; $.565 return per dollar invested over the last decade means investors have discounted a perpetual annuity. For central product pipelines, this may be the case. However, useful lives of field-level gathering assets depreciate as fields deplete. Thus, many pipeline projects and companies are, in aggregate, not likely to ever return real profits.

Moreover, the trend for the industry's CFROI generally is down. Even the integrated majors have suffered diminishing returns on invested capital. While downstream efficiency gains have offset declining upstream returns, this inverse relationship is not indefinitely linear. Modern oil refineries are not likely to improve much upon 10% heat inefficiencies (i.e., 90% of the potential energy within a given barrel of oil is used to convert that barrel into value-added downstream products). Although modern oil refineries can often achieve barrel-equivalent yields greater than 100% on crude feeds, cost efficiencies are highly dependent on grid energy and/or natural gas costs.

GAAP cash flow data is generally consistent with intuitions on declining energetic returns. Due to the high-grading effect, depletion tends to diminish resource quality, which, in turn, tends to raise the cost curve over time. Energetic measures of energy production, such as energy return on energy invested (EROEI), indicate that energy production which does result in a net energy surplus is never an efficient use of capital. Energy economists have long theorized that declining energetic returns would eventually manifest themselves as declining financial returns. This particular convergence between energetic and economic measures lends credibility to Gail Tverberg's variation of this view that market measures of capital efficiency are, on average, sufficiently indicative of resource quality.

Figure 1: Aggregate FFAR - U.S. Publicly Traded Energy Companies, 2007-2016

(Source: Portfolio123; Author's calculations)

Figure 2: Cumulative FFAR - U.S. Publicly Traded Energy Companies, 2007-2016

(Source: Portfolio123; Author's calculations)

Looking Forward

I believe the trend of diminishing returns is likely to continue.

In the short term, I expect that additional downward pressure may come from expanding service provider margins as the industry continues to re-normalize to the present-day commodity price environment.

Over the longer term, the narrative on diminishing resource quality is fundamental. Although one could argue that the onset of higher costs from diminishing resource quality will eventually translate into higher oil (USO) and gas (UNG) prices, the last cycle has shown how changes in prices roughly elicit a proportional (yet somewhat delayed) response in costs; i.e., the cost elasticity of price is basically parity. Furthermore, prices which rise too much only instigate (accelerate?) demand destruction and lower switching costs to substitute energy and hydrocarbon sources (and arguably, lead to much lower prices).

While it may be the case that recent technological breakthroughs have sustainably lowered the resource cost curve, the net result lowered price realizations by equally as much or more. Thus, technology has not fundamentally changed industry-level economics. Relative technological advantages, however, can and do favor certain producers.

Furthermore, declining returns in the oil patch have spurred investments into substitute technologies which are recently beginning to rival oilfield economics. This trend, whereby alternative energies grow in efficiency while conventional energy sources diminish, is expected to continue for the foreseeable future. Governments will naturally like to take credit for an eventual switch. In any case, from here on out, I believe the probability of positive petroleum demand shocks is virtually nil. And if anything, negative demands shocks are far more likely.

The Path to Rebalancing

Contrary to appearances, my research is not intended as an invective against the oil patch. Cost-effective and abundant petroleum-based energy sources and hydrocarbons have accelerated mankind's progress more than perhaps any other single factor. Moreover, there will always be a market for commodities whose derivatives (e.g., plastics, fuels, building materials, and all manner of synthetics) are highly valued. Rather, it is simply an observation that secular declines in CFROIs (and EROEIs) are a clear market signal of the industry's need to downsize (i.e., shutter marginal production). Most pundits look to OPEC to play the role of shutterer. However, typical OPEC production is not indicative of marginal production. It is this author's opinion that, due to low interest rates, continued investor interest, and vast unconventional resources, a supply-side response which is not market-driven is not a realistic path towards sustained rebalancing.

Judging solely from the cash flows, it seems that independent producers - who have invested 15% more cash than they produced over the last decade - are most vulnerable to shuttering by market forces. Of these, larger-sized producers are in the most precarious position, since they must achieve typical returns without the benefits of downstream price uplift. Smaller producers may be vulnerable as well, but their outcomes are more varied. A shock to US independent producers could elicit a major market shift, since, according to the IPAA, "independent producers develop 95 percent of domestic oil and gas wells, produce 54 percent of domestic oil and produce 85 percent of domestic natural gas".

Extrapolating on this trend paints a picture of the future which is not necessarily inimical to petroleum production but is antithetical to investment value creation within this space for the foreseeable future. An analogy to the airline industry throughout most of its livelihood seems apropos. And just like the airline industry, it is plausible that the upstream industry's re-rationalization could take decades of introspection and consolidation.

The Investor's Dilemma

Given that: a) energy companies have provided no real compounded return on investment since 2007; b) this period's capital outlays closely approximates asset replacement costs; and, c) this trend will persist and deepen, I believe the investment value of the aggregated energy industry is mostly a function of riding out any "residual" value - i.e., the aggregate sum of hypothetical future cash flows if upstream companies were simply to halt all investment into replacing depleted reservoirs in order to ride out their assets' underlying cash flows. This purely fictional construct attempts to compensate for the fact that pure cash flow measures of profit neglect the value of sunk costs.

Since future growth expenditures are unlikely to add substantial value, the worth of any given producer's future production (i.e., cash flows from known hydrocarbon deposits) is often a fair proxy for the intrinsic value of all its production assets.

Quantities of economically recoverable, developed and undeveloped petroleum resources are canonically classified as reserves. Yet, I prefer to avoid those terms due to their many unintended connotations (in terms of future commodity prices, probabilities of resource size and recoverability, fuzzy cost assumptions, regulatory and accountancy minutiae, etc...). Unlike frequently cited reserve-based measures of economic value (e.g., NAV and NPV), estimates of net future cash flows may be more generally defined by terminal economic and energetic limitations, which are further subject to capital budgeting decisions (e.g., based on production scenarios which assume either no further sustaining capital and/or no further growth capital). That conventional GAAP accounting metrics have been shown to be far more predictive of oil & gas companies' future equity returns than industry-specific metrics corroborates intuitions for using cash flow-based measures of value.

Figure 3: The Resource Pyramid

(Source: Author. The Resource Pyramid. Drilling for Value, Pt 2: Fundamentals of Petroleum Resource Management)

This premise seems simple enough, yet I have consistently found it difficult to identify bargains in U.S.-traded equities. For one, there is a tremendous level of uncertainty in assessing the economics of recoverable resources, since they are located far below the ground. But the crux of the issue is not so much due to the difficulty in assessing commodity-based business models, but rather due to the systemic over-capitalization (i.e., "overvaluation") manifest within present-day security prices. It may be notable that security prices which discount much higher energy prices appear to be a violation of the no arbitrage principle.

Even if many producers produce economic profits over their lifetimes, it is my experience that the majority of them trade at prices well in excess of future undiscounted cash flows. In turn, those which are apparent bargains at present-day spot prices are often marginal and vulnerable to seemingly minor changes in market conditions.

There may be exceptions, of course, but I argue that upstream-focused companies which post consistent profitable growth are outliers from the structural trend of cash flow shortfalls and diminishing returns.

Parting Thoughts

Given the industry's poor economics and overcapitalization, I am not really surprised by the recent sell-off, which saw the S&P 1500 Energy Index fall only by 5.36% from April 1 to June 15. If anything, I am surprised that energy producers have shown incredible unexpected resiliency through the downturn, given that WTI traded down 9%, from $50.25 to $46.10 per barrel, over this period. This relative market price resilience reflects the longer-term trend, since oil prices began to tank as of October 2014.

Given the long-term divergence between commodities prices and producers' equity market valuations, I believe that even more selling is warranted before the domestic and global energy markets can fully rebalance. Further devaluation is not only justified at the asset level but also healthy for the market over the longer term. Higher interest rates could catalyze such a shift as investors plow proceeds from equity sales into fixed income. Valuations of "bond-equivalent" stocks such as moderately high-yielding integrated oil & gas majors are particularly susceptible to this particular devaluation scenario.

Figure 4: Energy Industry Total Indices vs. WTI Spot Price: 2014 October-2017 June 15

(Source: Portfolio123; Author's calculation)

Note to Figures 4: Total Return Indices are constructed according to a modified capitalization-weighted LasPeyres methodology. This method adjusts previous close prices for the effects of dividend, splits, and other corporate actions. Industry Total Return Indices aggregate returns according to a company's primary GICS code. Calculations included all U.S. publicly traded companies in the Portfolio123 database for which prices and share information were available point-in-time.

The irony of my broad cynicism versus my recent picks, marginal oil sands producers Imperial Oil Corp. (NYSEMKT:IMO) and Cenovus Energy (NYSE:CVE), highlights the considerable price risks in this industry. While I stand by my positions at $50 per barrel WTI, I would hesitate to continue to do so if I felt the equilibrium price were lower than that. A thesis based on scale, longevity, and growth potential, but narrow netbacks, does not grant wide margins of commodity price error. Even so, their upside leverage to commodities prices is significant.

Given my views that commodity markets are generally efficient (i.e., discount all known information and/or are difficult to outguess), I am loath to making specious macro-economic calls, but in this instance I feel the data is compelling. Systemically unprofitable growth signals: a) the need for major industry downsizing and consolidation; and/or b) the end of the global order which has, for two centuries, equated petroleum resources to geopolitical power and wealth.

In conclusion, I believe specialist energy investors can potentially do well in this space - e.g., by buying and selling based on recent news developments. However, I believe self-selected investors in this highly commoditized space should consider themselves handicapped versus investors in other industries, since the ergodic long-term return of any given producer is probably less than zero. In addition, I believe longer-term investing in this space is an implicit bet on a perpetual supply of new investment capital. Yet, if history is prelude, betting on an endless supply of ever-greater fools is not a good long-term operating assumption.

Even if there are occasional deep-value opportunities in the oil patch, I feel most generalist investors are better served to leave dumpster diving to the specialists (i.e., those investors with access to institutional money and expertise, and proprietary data).

Disclosure: I am/we are long CALL OPTIONS IN CVE AND IMO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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