Here's What's Missing in the Energy Debate

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Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 17 years of industry experience, 13 at Heartland.


Transcript

When we look at the weakness in oil prices today and compare it to 2014, there are some similarities.

The big similarity would be supply: too much inventory of crude in the global economy.

The difference would be who’s the culprit.

In 2014, OPEC deliberately ramped up production to take market share and try to turn off U.S. shale production. They were successful for a moment. Oil prices plummeted significantly, so much so that it wasn't palatable for their budgets, etc., that they stop producing as much.

2014: OPEC Ramps Up Production

Heartland Advisors value investing market insight crude oil chart

Source: Bloomberg, L.P., 1/2/2014 to 3/31/2015 for Crude Spot Price, daily; 1/31/2014 to 3/31/2015 for Crude Production, monthly

But what was interesting about that? Since they drove down prices so much, costs—to activate a well, to service a well—plummeted significantly too and allowed U.S. producers to ramp up production quite meaningfully. In fact, they've exceeded expectations in terms of their production growth this year.

Lower Costs Enable U.S. Producers

Heartland Advisors value investing market insight US production chart

Source: Bloomberg L.P., 7/1/2016 to 6/30/2017

When we look at the backdrop today we wonder if perhaps the broader capital markets might be extrapolating too much from what we’ve seen over the last several months—meaning production growth has been so strong it can only continue.

Our hunches is, at low $40 crude if you will, just looking at the economics across all the basins: Yes, some basins are doing quite well, but not every E&P is doing great. In fact the vast majority of them here in the United States are out-serving their cash flow by a meaningful amount.

We would not be surprised to see, perhaps, production cuts in the second half of this year. And that certainly would be out of consensus right now.

If that happens, certainly the decline rates come into play too, which are very, very high. And that could lead to, perhaps, production numbers coming down further than anticipated, which would lead to more exasperated inventory draws, which would be helpful to the broader commodity complex.

Another piece that we think is missing in this conversation is the lack of investment that we’re seeing in non-OPEC, non-U.S. production. It’s a big amount. It’s over 40% of worldwide volumes. And we’re entering our third year where there just hasn't been that degree of investment to start up new wells, maintain existing wells.

So at some point we’re going to see that production level come down.

Now, the decline rates there aren’t as severe as, say, the U.S. shale producers, where they see decline rates of 40% or more. It’s more in the 13% level, but eventually, because the underinvestment has been so severe, this is going to lead to production declines which, again, would be a potential driver for future commodity prices or oil prices in the future.  

At the end of the day, it comes down to utilizing our investment process, our 10 Principles of Value Investing™. Whether it's a company in the Energy patch or in the Information Technology space, we utilize the same process. But, specific to Energy, we think our 10 Principles™ line up quite well, and I’ll highlight a few Principles™ that we think really stand out when we’re looking at the commodity-related sector.

  • Certainly you need a catalyst for recognition. And today, if we are in fact in an environment where we’re in a lower-for-longer commodity environment or crude environment, you’ve got to have a company on the E&P side that perhaps is in the right basin, where their cost to produce is very competitive on a global scale.
     
  • When we think about the quantitative components of our 10 Principles of Value Investing™, say price-to-cash-flow or financial soundness, on the cash flow side we’re going to run sensitivities. Back to those E&Ps, if commodity prices stay at or oil prices stay at $40 a barrel, what’s the cash flow that they’ll be generating? If we lift them up to $50, what's the updraft that we would see from that? Because they need that cash flow to service the debt on their balance sheet.
     
  • Moving to financial soundness: If, again, we’re in a period of lower-for-longer commodity prices or oil prices for the next 12 to 18 months or longer, are these companies going to be able to withstand a low environment in terms of pricing? Are we going to be surprised by, perhaps, a equity raise or additional debt taken on the balance sheet, or heaven forbid could we see a capital loss because commodity prices have been so low?

So, we think our 10 Principles™ match up very well when we’re looking at these companies because it allows us to consistently look at a company the same way.

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E&P refers to an exploration and production company
Decline rates refer to the slowdown in the rate of production from an oilfield following a peak in production

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