For more than 150 years, drilling for oil meant understanding the science of geology.
Last week, as oil prices crashed on simultaneous supply and demand shocks, industry experts turned to mythology (“The pillars of Hercules crashed together”), and even polemology, the study of war. “Armageddon,” one analyst warned.
The international oil benchmark, Brent crude, fell 24% on Monday, the steepest drop since 1991, and then another 11% over Wednesday and Thursday. All told, the price for Brent has been cut in half this year.
This “war” is ostensibly between Russia and Saudi Arabia. Russia rejected a plan from OPEC (the Organization of the Petroleum Exporting Countries) to cut production, given the likelihood of lower global demand. Saudi Arabia increased its oil output in retaliation. The real target, however, has been the U.S., and the dozens of American companies that have been drilling feverishly in U.S. shale plays, stealing market share from the international giants. The shale drillers depend on capital markets for financing, and no one will give them loans when oil prices are below $40. Several will have to go out of business or be swallowed by competitors.
“It’s really the end of so many companies,” David Heikkinen said on Monday. “You couldn’t imagine a supply war in the middle of an economic recession.” Heikkinen, the CEO of Houston-based equity research firm Heikkinen Energy Advisors, said he was having trouble reaching the oil companies he usually talks with, because they were rewriting their drilling plans.
Analysts expect the number of rigs drilling on U.S. soil to drop by at least a quarter. Evercore’s James West predicts the rig count will fall to 690 this year from an average of 920 in 2019. U.S. production could decline from a high of 13 million barrels a day—the highest level in the world—in November to 12.6 million, on average, in 2020 and 11.1 million in 2021, according to Stifel.
That could still prove too optimistic. OPEC and its allies are likely to flood the market with 3.5 million extra barrels of cheap crude a day, crowding out competitors. The world uses around 100 million barrels a day; a shift in demand or supply of a few hundred thousand barrels can cause double-digit price swings in normal times.
And the flood of supply comes just as the coronavirus pandemic is likely to destroy demand for several million barrels of oil a day. Jet travel alone uses about eight million barrels daily, and many planes are now grounded worldwide.
Investors have three options.
One is to ignore the industry entirely. That has been a smart choice for almost the entire past decade, during which energy stocks regularly trailed the market by double-digits. The industry’s debt position is ominous—oil and gas producers have piled on more than $120 billion in the past five years, and they still can’t consistently produce cash. In its latest report, the nonprofit Institute for Energy Economics and Financial Analysis found that producers had spent $5 billion more on drilling for oil in the previous four quarters than they had made from selling it.
Another option for investors is to buy energy stocks that could persevere amid low oil prices. Natural gas producers, for instance, outperformed last week after months of weakness. Gas producers should benefit as overall oil drilling slows, because oil drilling produces “associated gas” that has led to oversupply in the gas market. Take away that associated gas, and the price should rise. Cabot Oil & Gas (COG) is one of the safest gas plays.
Oil shipping companies can also persevere in this environment, at least in the short term. Oil is in contango, meaning that futures prices are trading above spot prices. It pays for companies to buy oil and hold it on tankers for later sale. “We believe the entire tanker sector should benefit,” Stifel analyst Derrick Whitfield wrote. His favorite of the bunch is International Seaways (INSW), which rose on the week. Other shipping companies that could benefit include Scorpio Tankers (STNG) and Euronav (EURN), according to Whitfield.
Refiners, too, would presumably benefit if oil prices are low for a long time, because crude is an input for them. Cowen analyst Jason Gabelman likes Phillips 66 (PSX), which has a strong balance sheet and can profit by refining crude produced overseas, even if U.S. production slumps. Gabelman likes Valero Energy (VLO), another large U.S. refiner that should see gains from some of the same dynamics as Phillips.
Still, the refiners’ stocks bounced around last week, with all the big American names crashing by double-digits on Thursday. Low prices may be good for them, but a global recession hurts demand for their products.
A third option—the riskiest but perhaps the most rewarding—is to bottom-fish for oil producers that have been beaten down and could snap back smartly.
One stock that several analysts have recommended in recent days is Concho Resources (CXO), a Texas driller that has hedged most of its production this year at higher prices. Even at $35 a barrel, it is one of the least leveraged members of the industry and could rebound once prices recover, analysts say. Trading at $39, it is miles away from the average analyst’s target price of $96. Still, Concho—like most other producers—has rarely generated positive free cash flow, even at higher oil prices.
And there is no particular reason to think petroleum will rebound in the near term. Goldman Sachs analyst Brian Singer estimates that oil could fall to the “cash cost” of production for U.S. and Canadian drillers, which he estimates as being in the mid-$20s.
“It’s rational to think you’re looking at a year’s worth of disruption,” says Andy Brogan, leader of EY’s oil and gas practice. “The trajectory out of the disruption is a bit unknowable. For the first time since the financial crisis, we actually have a market that’s shrinking.”
Bankruptcies are inevitable, though they might not happen immediately. The oil-and-gas industry was forced to restructure after the 2014-2016 oil price crash, which pulled Brent crude down to $28 a barrel from $118. In 2016, 70 North American oil and gas producers filed for bankruptcy, according to the law firm Haynes & Boone.
However, companies have learned some lessons—about hedging oil prices and restraining growth in their capital budgets, for instance. In 2017, there were just 24 bankruptcies. But too many drillers have feasted on cheap debt since than.
“Bankers will be unwilling to refinance at this time, given how much riskier the sector has become with geopolitical factors well beyond their control,” Kathy Hipple, an analyst at the Institute for Energy Economics and Financial Analysis, wrote in an email to Barron’s. “Some frackers have, indeed, hedged and have become more efficient at production—but remember, they’ve been cash flow-negative, in aggregate, for a decade, with higher oil prices.”
Among the companies that Hipple pointed to as having troublesome debt loads is Occidental Petroleum (OXY), which slashed its dividend by 86% and its 2020 capital spending by 32% on Tuesday. Its decision to buy Anadarko Petroleum last year leaves it with $38.5 billion in debt sitting heavily on its balance sheet.
Predictably, yields for energy stocks in the high-yield debt market spiked last week. Deutsche Bank projected at the start of the year that 15% of high-yield energy debt would end up in default, but now expects the market to go “materially above that.”
Indeed, even debt of companies listed as investment-grade, including Occidental, Continental Resources (CLR), and Ovintiv (OVV), have been trading at distressed levels—more than 10 percentage points above Treasuries—at times.
Predicting which companies go bankrupt is not necessarily a useful pursuit, however. Stifel’s Whitfield expects the actual bankruptcy rate to be relatively low, despite the distress, because “banks don’t want to own that many energy companies.” He expects many lenders to restructure the debt to keep producers afloat.
It’s more useful to consider which companies might cut their dividends.
The two biggest U.S. oil producers, Exxon Mobil (XOM) and Chevron (CVX), offered investors little in the way of new guidance last week, although analysts suspect they will provide updates soon. Few on Wall Street expect near-term payout reductions from either of those heavyweights. But J.P. Morgan analyst Phil Gresh thinks Chevron should immediately cease its stock buybacks.
Asked about its buyback, dividend, and drilling plans, a Chevron spokesperson wrote that the company has the strongest balance sheet and lowest breakeven prices in the industry, but added that it is “reviewing alternatives to reduce capital expenditures.”
Exxon, which presented an aggressive drilling plan to investors just a week before the crash, had no update about its intentions, aside from pointing to a statement that CEO Darren Woods made at its investor day, which said that the company will “continuously evaluate our priorities.” The energy giant paid out $14.7 billion in dividends to shareholders last year; its $5.4 billion in free cash flow didn’t come close to covering it. Exxon’s dividend yield was over 9% at the end of the week. Chevron’s hit 6.2%.
Oil services companies—particularly those that drill on land—could be in even worse shape than the producers.
Bernstein analyst Nicholas Green pointed to five that he thinks need to cut their dividends sooner, rather than later: TechnipFMC (FTI), Helmerich & Payne (HP), Patterson-UTI Energy (PTEN), Petrofac (POFCY) and Schlumberger (SLB). He wrote that “our models show insufficient free cash flow out to 2022, even before the latest crash.”
None of those companies responded to requests from Barron’s for comment.
In the long run, the U.S. shale industry will survive after a painful retrenchment. Saudi Arabia and Russia’s “power” moves are actually a sign of weakness, some experts say.
“This is the death rattle of OPEC really,” argues Ryan Giannotto, director of research at ETF provider GraniteShares. “They not only failed to reach an agreement; the agreement they reached was to all-out destroy each other.”
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