Several fundamental headwinds will ratchet up the pressure on exploration and production companies over at least the next six to eight months.
For one, the hedges that helped to insulate some upstream operators from the severe downdraft in crude-oil prices will roll off, pressuring cash flow. Borrowing base redeterminations could also constrain some companies’ liquidity, while the cost of debt capital has increased significantly for high-yield issuers.
Extracting oil and gas is a capital-intensive endeavor. An extended period of elevated oil prices helped to fuel the shale revolution, but ready access to low-cost capital also played a critical role.
The majority of shale producers operated at a deficit in recent years, investing more in their operations than they generated in cash flow. These shortfalls forced them to borrow and issue equity to fund the difference.
The severe downdraft in the prices of crude oil, natural gas and natural gas liquids has pressured producers’ cash flow and outpaced reductions to service costs and capital expenditures. Accordingly, the cash flow shortfalls that predominated in the salad years have continued in the lean years, setting the stage for further spending cuts in 2016.
In this environment, names with high levels of debt service relative to their revenue and limited capacity remaining on their revolvers face the most risk, though all exploration and production companies will feel the pain.
Nevertheless, we have started to become incrementally more bullish on select oil and gas producers with high-quality assets, strong balance sheets and enough portfolio optionality to privilege returns over production growth at any cost.
From the end of 1989 to the end of 1995, the S&P 500 Energy Index managed to eke out a 76.7 percent gain despite a prolonged period of weak commodity prices.
Energy stocks underperform when oil prices plummet; however, the sector can deliver solid returns when oil prices are lower, provided that they trade within a range.
In a scenario where oil prices remain lower for longer, investors should focus on upstream operators with strong balance sheets, low production costs, a history of solid execution and franchise assets that can deliver output growth in a challenging environment. Names that can grow production and win market share should outperform, while their cash-strapped peers or those with inferior assets will struggle.
Extended periods of weak oil prices traditionally have encouraged mergers and acquisitions, as well-capitalized companies look to build scale and drive growth–these are the names investors should own.
The universe of exploration and production companies that meet our criteria is relatively small–only five stocks made the cut–so don’t misconstrue this call as open season to buy upstream names indiscriminately. Not every oil and gas producer has the potential to outperform, let alone survive.
In the Sept. 26 issue of Energy & Income Advisor, we highlight a handful of our favorite names to scoop up during the coming buying opportunity. To help with timing, we’ve included dream buy prices for these stocks that reflect trough valuations in previous downturns and our outlook for commodity prices.
Elliott and Roger on Sep. 30, 2020
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