“…boys, you're not making money in the $50s, okay? Get over it.”
– Harold Hamm
Tariffs, global growth concerns, productivity, and supply…oh my! Those are the central themes to news articles relating to the global energy ecosystem hitting our inbox today. But let’s put geopolitics aside this morning. I won't waste your time on China, Iran, Saudi Arabia, or Russia. I have no edge on how those volatile dominoes fall. Fortunately, we do employ a couple macro guys to help us navigate the icebergs of the #Quads. You may recognize their names.
Instead, I will focus more myopically on North American E&Ps, midstream, and oil field services. In 18 months, investor sentiment surrounding Energy equities has moved from apathetic to outright scornful. And rightly so.
Here are of some of my favorite headlines describing the self-inflicted carnage:
- “Shale Companies, Adding Ever More Wells, Threaten Future of U.S. Oil Boom”
- “Shareholders Have No Love For Shale Companies”
- “The Next Financial Crisis Lurks Underground”
Today’s focus is on the aftermath of the cheap-capital production boom that achieved the goal of “US Energy Independence,” but destroyed massive amounts of value for the debt and equity holders who funded it.
Let’s put some numbers behind headlines.
Between 2012-2018, our sample of 59 US Independent Exploration & Production companies drilled ~$725B into the ground, burning ~$200B in cash at commodity prices 25% higher than today. The cash burn was funded by a mix of equity, debt, and asset sales. With that capital, E&Ps earned a recycle ratio – how much EBITDA is generated per dollar of expenditure – sub 2.0x in every year except 2018. A recycle ratio in excess of 2.0 is needed in order to achieve the critical value creation equation ROIC > WACC.
At the company level, nearly 90% of US independent production fails the 2.0x recycle ratio test. If we lower the recycle ratio hurdle rate to 1.5x, only 30% earn their cost of capital. With that backdrop, it’s no wonder that investors have left energy executives to their own devices. Tack on a healthy dose of skepticism about the future productivity of the asset bases, competition from renewable energy sources, regulatory risks, and ESG concerns, it makes sense that the XOP is bouncing off the bottom of all-time lows.
“…we need to think global as far as [the] market, what is the overall world demand, how do we play into it? And we shouldn't be oversupplying it. That doesn't work well. Hadn't worked well for gas, won't work well for oil. So we need to be very careful. And it's this thought about that I hear a lot. ‘Well, we can produce oil in the 40s, we can produce oil in the 30s.’ Let me tell you, boys, you're not making money in the 50s, okay? Get over it.” – Continental Resources CEO Harold Hamm
After all the doom and gloom on the US unconventional production ecosystem, it’s time to tie the title into the text. It’s big, it’s not sexy, and it resides North of the Border, but if you’re interested in finding value in the most hated sector of the market, we see Canadian Natural Resources (CNQ) as a place to hide. Its low decline, ~1MMb/d primarily synthetic crude production base has manageable maintenance capital requirements.
Its path forward is the antithesis of US shale, where the repeatability of its low cost asset base can safely fund shareholder returns of a ~4.75% dividend and repurchases of ~5% of the shares outstanding. Leverage of 2.0x, valuation at 5.5x EBITDA and a 12% FCF yield are very attractive both relative to its sister E&Ps south of the border and the broader market. In the oil patch, this combination is about as rare as a sasquatch.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.48-1.66% (bearish)
SPX 2 (bearish)
NASDAQ 7 (bearish)
Utilities (XLU) 59.90-61.91 (bullish)
REITS (VNQ) 88.85-92.20 (bullish)
Financials (XLF) 25.77-27.25 (bearish)
Shanghai Comp 2 (bearish)
Nikkei 204 (bearish)
DAX 117 (bearish)
VIX 15.35-23.80 (bullish)
USD 97.11-98.46 (bullish)
Oil (WTI) 51.05-56.94 (bearish)
Nat Gas 2.03-2.23 (bearish)
Gold 1 (bullish)
Energy Sector Head