Overview of the Oil and Gas Sector

Hopefully this post will generate some debate with regards to profiting from the recent drop in oil prices. As we have done in the past, we will do a sector overview and we will unlikely hit on every aspect (that would require far too much work).  If Oil and Gas is not of interest to you, we have done the following sector overviews: 1) Financial Institutions Group, 2) TMT (Part 1) and TMT (Part 2), 3) Healthcare, 4) Consumer.

 

Overview: The oil market is seeing significant pressure from the declining value of crude oil. The price of crude has dropped from ~$105 in June of 2014 to ~$55 as of late December (West Texas Intermediate – WTI). In addition, the price of Brent has fallen from ~$105 to ~$60 in the same time period. For those that are interested the difference between Brent Crude and WTI crude, here it is:

Brent Crude: Extracted from the North Sea and comprises of Brent Blend, Forties Blend, Oseberg and Ekofisk crudes (also known as the BFOE Quotation)

WTI Crude: This is the underlying commodity of the Chicago Mercantile Exchange’s oil futures contracts. WTI is lighter and sweeter than Brent, and considerably lighter and sweeter than Dubai or Oman.

Why the Price Difference: Pretty basic here, the price differential is due to the increased transportation cost from Oklahoma to Louisiana. There is limited pipeline capacity. While this is likely extremely basic for those that work in the space, if you’re new to the space, the price differential of ~$4-5 is confusing on a glance.

While we could dive into the other baskets (Dubai, Oman etc.) we will keep it simple and refer to crude as WTI Crude since it is the underlying commodity in the Chicago Exchange.

Without getting into a lot of the details here, the main question most are wondering is what caused the price drop? Simplistically, oversupply of oil. Or an “oil glut”. If you want to look at recent catalysts that occurred… on November 27, 2014 OPEC elected to maintain its 30 million barrel per day output level which caused the market to decline. Why? It suggests that oversupply will remain (near-term) as they are not electing to decrease output levels that caused the glut in the first place.

To wrap up the overview, here are some high level numbers on an annual basis to be aware of:

– Demand: You’re looking at ~90-98 million barrels per day on a global basis, ~17-20 million barrels in the USA, ~12-16 million barrels in Europe and ~8-12 million barrels for china.

Supply: Naturally, given the “oil glut” you’re looking at supply that is currently outstripping global demand at a rate of ~1-2 million barrels per day. Simply put, it is estimated that the current output is supplying 1-2 million barrels more per day than is needed, causing prices to drop. To be crystal clear here, in the supply case we are not breaking it out by region as many regions are net importers of oil. For example, even if the USA demands 19 million barrels a day, the amount generated in the USA is less than 13 million barrels a day. The rest is imported from other countries.

– Future Oil Demand: The next question you are likely asking: “Is demand going to increase? If it does we have nothing to worry about”. This is a good question and for your back pocket using GDP minus 0.5% would get you to overall demand growth of crude oil.

There you have it. You now have a basic overview of what is occurring in the oil space. There is an over supply of ~1-2 million barrels a day. Demand for crude has historically increased just below GDP growth (this is a global GDP centric comment) and OPEC recently announced that it is not cutting production which led to additional pressure on Crude oil.

Natural Gas: Everyone is aware of what natural gas is: a fossil fuel that is created when plants, gases and animals are exposed to intense heat. Primarily, natural gas is used for heating, cooking and electricity.

Units to Measure: The conventional unit of measure is “million British thermal units” also seen as MMbtu. For this post we will refer to it as “million btu”. In addition, when looking at global numbers the convention is to refer to 1 billion cubic feet, this is equivalent to ~1 trillion Btu = 1 Bcf. For this post we will use the same convention and use Bcf.

Before moving forward, in case the paragraph is confusing, when people refer to the price of natural gas it usually refers to $/million btu and when you are looking at large scale supply and demand it is usually in measure of Bcf.

Given that the vast majority of you would work in the USA, here are the metrics for natural gas on an annual basis that you should be cognizant of:

US Demand: You’re looking at ~70-75Bcf in total demand. This is broken down as follows: ~20-25 Bcf Residential and Commercial, ~19-23 Bcf Industrial, 20-25 Bcf electric and 5-9 Bcf in other use.

US Supply: Onshore supply is roughly 30-33Bcf, Shale providers ~ 40-45 Bcf, Mexico wraps it up with ~3Bcf

Canadian Demand: While we are not going to go into this geography, it deserves a mention due to all the press it has received. The Canadian oil sands are responsible for roughly 13-17 Bcf per year and is primarily generated in Alberta and British Columbia.

The overview is now wrapped up with the high level numbers on natural gas out of the way as well. With that said lets move onto the sub-sector takeaways.

*Note: There will be some redundant themes similar to our other overviews as many items must be tracked across all sub-segments in the O&G space, we repeat them in case a reader is only interested in one section*

Global Oil and Gas (Chevron, Exxon and others)

Here we are looking at the large caps. As you’ve seen in the past when you look at larger scale companies you’re looking for Free Cash flow as your primary valuation metric. Given this dynamic and the size and scale of oil and gas companies (setting up new rigs, drilling sites etc.) monitoring and modeling out a CAPEX schedule is also of utmost importance.

In addition to these two highlights, the risks for large caps such as Exxon and others would include… commodity costs. Naturally, the recent oil price declines have caused stock price pressure across the board. Beyond this metric which is impacting the entire space, larger companies are also at risk to tax law changes, environmental and political risks as well.

Oil and Nat Gas Prices: As you can imagine this is a material driver of business viability and growth. Tracking the macro changes in Oil prices (movements of+/- $5 are quite material) and tracking the changes in Nat Gas prices (movements of more than 10-20 cents on a $/MMBtu are material).

OPEC: The next major meeting is on June 5, 2015. If demand and supply levels remain where they are we would hope for a decrease in daily barrel production. If you’re hoping that oil prices remain dirt cheap, then you’re looking for continued over supply. Keep it simple!

Wells and Drilling: For the major bellwethers, you are going to focus heavily on the future CAPEX and drilling sites as they will determine future cash flow. For example, the Company will give specific metrics on a location and drilling expectations and give % of complete metrics over time. In an ideal world you’ll see that project in location X has started on time and will be 100% complete within or before the allotted time frame with all wells firing at timeline Y. We realize the paragraph is a bit vague but if you read through the filings of major oil company you’ll find these percentages in the 10-Ks/10-Qs and analyst day presentations and earnings calls.

– Simple example from Q3 they talk about the LNG project in the press release: http://investor.chevron.com/phoenix.zhtml?c=130102&p=irol-EventDetails&EventId=5170148 (click on Q3 press release). This would represent an important talking point for investors/bankers.

Revenue Mix: As expected with the major companies you have larger line items to look at and are going to track margin profiles by region and sub sector. If you want to dig into the weeds again, refer to the Q3 earnings and look through the supplemental comments. This is where the “goodies” are. You can see breakouts by refining, actual volume, liquids, natural gas and the BOE (Barrel of Oil Equivalent). In an ideal world, all of these lines would see improving revenue and margin profiles. This is practically never the case so it is up to you to find the key metrics driving each P&L.

FX: This is a bit obvious and is only worth a quick bullet. Given the size and scope of these companies FX rates and changes can materially move the top and bottom line.

Assets Sales: Again, since we are looking at major oil corporations you’re looking to see if interest in specific production facilities are being sold (if unprofitable or at break even). You’ll be tracking these asset sales to assess the risk of the overall entity (For example: over exposure to a specific geography).

Valuation Metrics: The main items you’re going to look at if you wanted to check a quick comp sheet would be the following: the simplistic P/E ratio, P/FCF, EV/DACF and the dividend yield as many investors are looking for high yield securities. The only item on this list that may raise an eyebrow is DACF which is Debt Adjusted Cash Flow.

DACF = CFO + after tax financing costs + before tax exploration expenses +/- working capital adjustments

The reason this metric is used is due to the after-tax calculation, which makes the valuation independent of financing decisions made by the firm.

Refinery (Major players all here again, Marathon, ConocoPhillips, Valero and others)

We don’t need much description here as everyone is aware of what an oil refinery is: processing of crude oil into items such as petroleum, gasoline, kerosene etc. This is probably the piece of the oil industry that most think of when they hear “oil company”.

A Bit More Defensive: Since these companies need to refine crude oil, they are a bit less impacted by the severe drop in crude. Simply put, the crude oil needs to be converted so it won’t see a falling knife type stock chart if oil goes down $10 (reverse is of course true for an E&P company – more on that later). In fact the decline in the price of crude oil can help this segment since the cost of the main supply (crude oil) has dropped. Again it still needs to be converted to gasoline/kerosene or otherwise to fill the demand void.

Oil and Nat Gas Prices: While it should be tracked, as mentioned above, the changes are going to impact this space a bit less.

Large Capital Projects: The business model is more capital intensive. You’re looking for large projects that can help make or break companies as they refine large amounts of crude oil. Location is also key in this case as having access to large and cheap amounts of oil is beneficial.

Cash Returns: Not to the same extent as an MLP of course, but cash returns to shareholders are monitored closely. Given the size and scale of large refinery companies investors deserve solid capital allocation programs.

Exports and Macro: Given the large scale, these companies are a bit more lenient on the macro and US export laws/regulations. If you can’t sell the refined oil (export it) then… you’re simply losing that $$$.

Valuation: Keeping it simple again the main items you’re looking at are: 1) EV/EBITDA, 2) EV/Cash flow, 3) Tangible book value, 3) Dividend yield and total return to shareholders – including the share repurchase program and 4) annual EBITDA/Cash Flow Growth rates.

Master Limited Partnerships – MLPs (Dominion Midstream Partners, American Midstream Partners and others)

MLPs primarily pertain to the use of natural resources, such as petroleum and natural gas extraction and transportation. An MLP is a limited partnership that is publicly traded. The Company takes advantage of the tax benefits of being a limited partner, is liquid by being a traded security and pays its investors through a quarterly dividend (this is similar to a REIT).

Oil and Nat Gas Prices: As you can imagine this is a material driver of business viability and growth. Tracking the macro changes in Oil prices (movements of +/-$5 are quite material) and tracking the changes in Nat Gas prices (movements of more than 10-20 cents on a $/MMBtu are material).

Pipeline Business: If you want to boil down the business to a simple nugget, you’re obtaining a stable income from the transportation of oil/gas. With this in mind it is key to have a robust pipeline of cash flow positive business in the future to continue paying out dividends to your investor base. As you can imagine right-of-first-offer contracts become important to track so the companies you’re looking at can have a positive future run-rate of cash flow.

All Contracts are Not Equal: Since we are lining up large pipelines of deals, the type of contract will matter… a lot. You can simplify this point by thinking of getting a loan. A variable loan or a variable contract on a specific pipeline is not going to be as good as a guaranteed fixed line that you are certain will generate positive free cash flow. It is up to you to dig through the weeds.

Customers are Not Equal as Well: Since you are building a pipeline here, you want to have import customers that are solid (think companies like BP plc). This allows you to be much more certain about your order size and scale.

Less Mobile CAPEX: Since we are looking at longer term items some companies may or may not have large *committed* CAPEX spending in the future. Unlike E&P where it is a bit easier to shut down or ramp up CAPEX. This will impact valuation. This is particularly true if you have a lot of committed CAPEX spending into a declining oil price environment.

OPEC: The next major meeting is on June 5, 2015. If demand and supply levels remain where they are we would hope for a decrease in daily barrel production. If you’re hoping that oil prices remain dirt cheap, then you’re hoping for continues over supply production levels. Keep it simple!

Valuation Metrics: We’ll keep this a bit more basic as the main drivers are clearer and straight forward: 1) dividend yield and growth, 2) Discounted cash flow – we’re dealing with longer-term contracts to it makes more sense, 3) Net Asset Value, 4) EV/EBITDA or EV/FCF.

Exploration and Production – E&P (Pioneer Natural Resources, Devon Energy and others)

Also referred to as E&P for short, this sector has been impacted materially over the last 6 months as the title is self explanatory. These oil and gas companies specifically work in the exploration and production of oil, meaning that the significant price drop in oil has caused a lot of the business to become unprofitable. On a positive note, when the price of oil was in the $85-100 range, this segment naturally blossomed at outperformed the S&P since profitability was quite high.

Macro Trackers:

Oil and Nat Gas Prices: As you can imagine this is a material driver of business viability and growth. Tracking the macro changes in Oil prices (movements of $10 are quite material) and tracking the changes in Nat Gas prices (movements of more than 10-15c on a $/MMBtu are material).

Weather: One small overlap with the Consumer sector, tracking weather patterns is key. If temperatures drop materially, this can lead to higher usage of natural gas for heating. The reverse is also true if a winter season is unusually warm.

Capital Expense: If companies intend to increase drilling in the future and are taking out debt to do so, you can see how this will be a spiral downward or upward depending on the demand function. In a positive scenario, capex spend is high to continue finding more oil/gas and the price of oil and gas is high. In a negative scenario, companies are taking debt to search for oil that is not profitable.

OPEC: The next major meeting is on June 5, 2015. If demand and supply levels remain where they are we would hope for a decrease in daily barrel production. If you’re hoping that oil prices remain dirt cheap, then you’re looking for continued over supply. Keep it simple!

Location, Location, Location: No this is not a real estate speech. However. The location of where the oil is being primarily produced (this is on a company by company basis) can drive valuation in the future. Some locations are simply more profitable than others. For simplicity take a look at this Wall Street Journal chart: (Link: http://oilprice.com/Energy/Crude-Oil/The-US-Shale-Breakeven-Price-Debate.html)

You see that having a higher exposure to the Eagle Ford area for a company is significantly better than high exposure to Tuscaloosa Marine.

Hedging Contracts: Get your hands dirty and look through Company specific filings for hedging contracts. See if the company has specific oil/gas price hedges over the next year or so which protects them on the downside given the material move downward in oil prices. Smart companies will hedge a sizable portion of the headwind.

Net Debt: Finally the key balance sheet metric to monitor is net debt. Naturally if your leverage becomes to high and you’re trading at a large multiple relative to your EBITDA or FCF… This is going to trigger serious investor fears as debt default becomes likely.

Valuation Metrics: The items you’re going to look at if you want to create a solid yet simple comp sheet are as follows: 1) Net Asset Value (NAV), 2) Price to Net Asset Value, 3) P/E or Cash flow per share, 4) DACF (as seen in the global oil overview above) 5) EV/EBITDA and cash flow, 6) Debt/EBITDA and cash flow and 7) the same valuation metrics including/excluding hedges

Oil Services (Forbes Energy Services and others)

Now we’re getting to the final frontier, some more obscure oil companies. This is a bit of a catch all bucket where you’re looking for companies that assist in the oil production/drilling process. An example of a product would be machinery that assists in choosing the best position for an Oil & Gas Rig/Well.

Oil and Nat Gas Prices: As you can imagine this is a material driver of business viability and growth. If people are not drilling people are not going to need oil services. Lower gas prices do not help this sub-sector.

Cheap Assets to Buy? We are tossing this in here simply because the size of these companies are generally smaller. If their market caps/valuation come under extreme pressure there should be interest in buying the best of breed and tucking them into major oil companies. We are not here to speculate just pointing out the material difference in size of a smaller oil services company compared to a behemoth like Chevron.

Increases in Oil Efficiency: If the services companies are able to decrease the cost of drilling the business model will improve. In short, the technology/services they deploy need to improve the oil production process and your business will improve. This should be obvious but that is the real saving grace if oil prices remain low for the services sub-sector.

Valuation: Since this is a small sector the valuation metrics are pretty generic. Focus on 1) EV/EBITDA, 2) EBITDA Growth, 3) FCF metrics and 4) Dividend yield. Again, due to the pricing pressure from oil, it is imperative to find the companies with the best technology/services edge as they will eventually help the larger players turn a higher profit margin off of the drilling.

Basic O&G Specific Trade: For those that read the entire post you will likely understand the following trade. Lets *assume* you believe that oil prices are going to continue declining. Lets assume you are bearish and believe it will go to say $30 a barrel.

A portfolio manager asks you what to do in this scenario. You must make a play solely in the oil and gas field.

With your belief in mind, the move is to short the E&P sector and buy the refinery sector. This is because E&P businesses will have their business models dry up while refineries will be relatively agnostic to the oil price change.

If you believe oil prices are going to rocket back up to $100 soon. Then the reverse trade is the move to make.

Concluding Remarks

That does it for the O&G overview. In short you’re looking for the following:

1) Oil price and Nat gas prices and their impact on O&G Companies. Generally those more levered to the sourcing of oil will be hit harder where as those who use the oil for other products will be protected

2) OPEC always the overhanging macro piece of the picture

3) Free Cash flow and EBITDA is king given the size and scope of these companies

4) Follow the chain of events. IE: customers and contracts are never equal

5) Check the balance sheet: less debt in a low oil price environment is better and lower rates on the debt would add to that cushion

6) CAPEX is key. Many of these companies have large plans that may or *may not* be cancelled at any time.

7) Location! If you’re drilling in highly profitable areas you can wait out the storm as your break even levels for profitability will keep you afloat for a longer period of time.

8) Taxes – the entire reason for the MLP space, no one like taxes. Particularly people in Texas.

9) Hedges – commodity driven companies have a high interest in keeping hedges to protect the bottom line. Read the filings.

10) Weather – Generally, the colder it is, the more gas is consumed.

Per usual post up extra comments/questions.

Comments

  1. E&P Houston says

    Great article – I work in Equity Research here in Houston and I can attest to the accuracy of this information

    • Wall Street Playboys says

      Always! New Years eve is to get your ducks in a row. As noted in the previous post.

      The g is a temporary item. Our logo and banner is being redone will be fixed in a few weeks once the designer gets back to us.

  2. Anonymous says

    My brother is at a very good bank in Houston just outside the top 2 or 3, which have basically 100% placement into PE for analysts. Any advice on making the jump from energy IB to energy PE?

  3. David says

    Can’t comment on the quality of what you’ve written (others can, and have done so) – but the thoroughness and the investment of time and effort are commendable.

    It’s ‘bellwether’. WP says…

    The term is derived from the Middle English bellewether and refers to the practice of placing a bell around the neck of a castrated ram (a wether) leading his flock of sheep. The movements of the flock could be noted by hearing the bell before the flock was in sight.

    You can tell that to people in the bars. No need to thank me.

      • says

        One for mining please!
        I am trying really hard to break into a BB ib m&m group. Do you think its bad having a specific interest? Or should I just be open to work in any ib industry group?

        Gracias,
        El Pollo

  4. DaveK says

    Reading this from sunny southern Iraq, working for a major E&P company. Very interesting to look at O&G from a finance perspective, thanks for super informative post. All the best in 2015!

  5. Scott says

    I was hoping WSP would do something on oil/gas. Well done. I bought Hal at about 40 and am prepared to hold for a good while, and but more if it drops into mid-low 30’s ore below.. I believe eventually they will earn a higher multiple with their BHI deal. I also believe that oil is a political commodity and subject to the vicissitudes of the moment. Regardless of supply/demand, at some point some geopolitical event will take place that pushes the price of oil higher.

    • Wall Street Playboys says

      We never post predictions. Just dollar cost average into index funds like VOO until you are financially independent

      Posting predictions will just draw in idiots (see retail investors) which we have no interest in speaking to.

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