When I was a kid, I couldn’t wait for Thursday nights and Aaron Spelling’s television pièce de résistance, Dynasty. The current real world oil market drama has me flashbacking to Alexis Colby and ColbyCo, which was a privately held company that Alexis inherited when her husband died. Some fairly dynamic business storylines emerged, like when rival company Denver Carrington (run by Alexis’ ex-husband), briefly became a ColbyCo subsidiary in 1983 and 1986. Of course, love and business gushed between Alexis and Dex Dexter, in a partnership with Dexter International called, Lex-Dex. Drama around oil, its exploration and production, has always made for great television. Now, I think it too makes for great investment.
Oil markets are notoriously volatile. Years like 2008 are still clearly engrained in the memories of commodities traders – where prices peaked at $127, only to end the year at $36. More recently, 2012 saw a crude oil pricing rollercoaster ($105 - $83 hi/lo range) fueled through a variety of factors articulated by the US Energy Information Administration:
- Changes in Global Economic Growth Expectations - Strong job growth data in the US, lower interest rates for several European countries and increased manufacturing data in China all contributed to increased expectations for economic growth and higher crude oil prices during the first quarter of 2012. A reversal of these factors in the second quarter helped push crude oil prices to their 2012 lows.
- Oil Supply Disruptions - Production disruptions such as those in Syria, Sudan, and Yemen took about 1 million barrels of oil per day off the world market, raising oil prices.
- Iran Sanctions - Ongoing US and European sanctions on imports of Iranian oil intended to pressure Iran to give up its nuclear program (1) played a part in reducing Iran's oil exports, and (2) raised fears that Iran would retaliate by disrupting oil shipments through the Strait of Hormuz. Both caused oil prices to rise.
- Rising Oil Production - US oil production topped 6 million barrels per day in early 2012, the highest level since 1998, and contributed to building US crude oil inventories that put downward pressure on oil prices.1
Funny thing about these four items is that they're from 2012, but it could have just as easily been referring to the past year’s news headlines. However, there are some fundamental shifts in oil production that have already impacted the industry, and will continue to do so for some time. In the chart below, since 2000 though world crude oil production has increased 20%, US oil production has increased at a staggering 50%.
The technological innovation known as hydraulic fracturing (or fracking) has been a key factor in the US oil (and gas) production dominance. When only a decade ago, many talked about the US’s reliance on foreign oil, now the conversation has turned to when precisely the US will have total energy independence. Meanwhile, in the same chart, oil rigs pulling crude from the ground are down nearly 50% during the same timeframe. Production is way up, but rig count is way down – one of the key features of technological innovation in action. It also means that mergers and acquisitions can be more rampant in this sector. Ideally, M&A activity generates greater operational efficiencies and stronger corporate earnings. From April 17 - May 16, 2016, the oil sector recorded nearly $8.4 billion in deals – which is the highest tally since July 2014's $12.9 billion – when oil prices were $100/bbl and gas prices were near $3.75/Mcf. The biggest motivation for this recent uptick in M&A is that most participants believe that oil prices have bottomed and that there will be higher prices by year-end.2
Acquisition opportunities for the sector’s strongest cash flow and financially sound oil companies abound. Year-to-date energy companies have defaulted on $28.8 billion of debt, according to Fitch, putting the sector’s default rate at 15%. For exploration and production companies, the rate is 29%.3 These default events weigh heavily on equity valuations, making them prime for picking at pennies on the dollar. The positive outlook on oil prices fuels the consolidation activity. One factor in higher forecasted oil prices is the historical link between GDP and oil prices. In the chart below, we can see a steady march upwards in oil prices in perfect correlation with US monthly GDP, during post-2008 recession, as the US economy recovered. Oil shocks described earlier derailed the continued march, while GDP continued upwards. Now, there’s a wide divergence, and oil has quite a bit of catching up to do, and could do so in very short order.
It’s probably best to ask “What Would Alexis Do?” In between the occasional cat-fight, I think she’d look to pick the carcass of some near bankrupt operation. So, if you’re looking for ways to profit in today’s market, look for oil companies that fit the ColbyCo profile.
1http://www.eia.gov/todayinenergy/detail.cfm?id=763...
2http://www.ogfj.com/mergers-acquisitions.html
3http://blogs.wsj.com/moneybeat/2016/07/12/junk-bon...
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Source: Equities.com News
(July 15, 2016 - 12:24 PM EDT)
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