The Rising Influence of Rising Affluence

[mr_o]

Opportunities and Risks for Investors After the Oil Price Slump? - (PIMCO)

The recent collapse in oil prices has prompted global producers to make drastic cuts in exploration and production. This year, capital expenditures for oil and gas will likely be slashed by some $24 billion, including $17 billion in the U.S. alone, although budgets are being revised almost daily as the market tests the “floor” for oil prices.

In absolute terms, these are large cuts. However, relative to the oil and gas industry’s overall global capital expenditures, expected to be close to $1 trillion this year, the amount is small. So small, in fact, that the cuts are unlikely to pose any real risk of supply shortages in the near future and should not threaten securing global supply of 93 million barrels per day. Even though many U.S. companies are dropping capex sharply, the international oil majors and national oil companies are committed to very large long term investment programs that remain in place despite short term volatility in prices.

Over the past decade, a surge in investments in exploration and production has transformed the industry dynamics, with supply ample and more diversified and OPEC’s share in decline. Upstream capex has grown three-fold over the 10 years ending in 2014: Output grew 10.6%.The U.S. shale revolution has been the main contributor to diversification and security of supply. U.S. shale accounts for 17% of total global oil and gas capex including exploration, drilling, development and completion. That said, opportunities in frontier areas such as West Africa – where capex growth since 2004 has almost equaled that in the U.S. – and a more stable political and legal environment for investment have also made other countries more attractive. Investment in oil and gas over the past 10 years has been concentrated on diversifying supply outside of traditional basins and OPEC countries. This expansion has helped to secure the biggest growth in non-OPEC supply in two decades, and triggered the recent decision from OPEC to abstain from its traditional intervention and let prices fall in order to maintain market share.

But oil investments have also been rising on the back of a pro-cyclical cost curve. That is, service costs and development costs tend to rise as oil prices go up, driven by excessive increases in investment. The oil industry has gone from underspending in the late 1990s to overspending on the back of growth in demand that has proven elusive. Many of the investments made in the 2004–2013 period have created overcapacity in the system. Additionally, improvements in efficiency and a transition to a less industrial-based model have broken the correlation between real GDP growth and energy demand. We do more with less: The number of barrels of oil consumed per additional unit of GDP in the U.S. is lower today than 30 years ago, while the world´s oil intensity (barrels consumed per $1,000 of GDP) has been declining by 2.4% per annum for a decade.

What we are seeing now is that oil prices, when OPEC refuses to balance the market, test the marginal cost of production, and costs fall. Some of the costs of the largest components of oil projects – high-spec sixth-generation rigs, pressure pumping, seismic, completion – have fallen between 20% and 45% in the space of months as overcapacity became evident and capital expenditure was revised downward. In a very short period of time, from September 2014 to January 2015, we have seen industry talk of overall cost reductions of 15% to 20%; this should lead to improving breakevens, and the widespread perception that the industry requires prices north of $65-$70 per barrel to deliver production growth will likely be rethought.

We have seen this before in previous periods of excess supply: Costs go down. Between 1985 and 1986, capex fell across the international majors, and operating costs per barrel plummeted 30% on average in one year. Quite similar to the cuts we have seen in the past months.

In the U.S., recently announced cuts already surpass $12 billion, and could rise as high as $17 billion for all of 2015. This, added to the 20%–25% cost reductions noted by the large service providers, could lower the average U.S. shale breakeven to $40–$45 per barrel. Industry self-help comes to the rescue!

The cathartic effect of low oil prices for the global oil and gas companies has so far created a strong enough response through reduced expenditure to allow the industry to survive the lean period. But where is the growth?

Unlike in the 1986–1998 period or in 2009, when the reduction in international oil companies´ capex was more than offset by investment from state-owned companies, this time investments are being reduced both at the National Oil Company (NOC) and international (IOC) level.

Waiting for prices to rise or other bottlenecks will be obstacles to achieving cleaner, safer and more affordable energy. Technology and improvements in efficiency will be the answer. Therefore, the industry will need to find new ways to finance investments to guarantee the security of supply in the next years as well as to continue the journey down the path to energy independence underway in the U.S.

There needs to be a process of restructuring and consolidation where the inefficient or highly indebted producers give way to stronger, more efficient companies that structure their business and investment to attain solid returns at mid-cycle prices, instead of betting on “higher for longer.”

Companies must start planning for a demand that is not going to grow as the old models predicted. OECD demand peaked in 2007 and non-OECD demand has partially been a self-fulfilling prophecy, driven by oil-producing countries´ own energy demand growth as prices rose. Higher revenues from oil exports created stronger GDP growth, larger investments in infrastructure and an unprecedented growth in energy demand in the oil-producing countries – well above certain developed countries’ average in some cases. This phenomenon also reduced effective exportable capacity. Therefore, as oil prices fall, it is likely that producers’ own oil demand will also moderate and exportable capacity will normalize. Non-OECD demand is also likely to be disappointing as China changes its model to a more sustainable one and technology and efficiency help the world improve its growth prospects with less energy consumption.

The financial industry will be instrumental in changing the landscape of energy investing. Capital increases to reduce the debt burden are required at both large and small companies, while mergers will be necessary to create stronger entities with diversified and robust portfolios where investments in growth are not dependent on peak cycle prices. In the same way that investors partnered with companies to solve the problems of natural gas producers when Henry Hub gas prices collapsed, investors can help reshape the position of alternative energy (wind and solar) companies to be able to deliver returns without betting on more subsidies or aggressive prices.

Investors should try to avoid waiting for or banking on an “oil back to $110” scenario and focus on four main points:

Avoid value traps and “cheap-for-a-reason” stocks: There are plenty in the oil and gas space, which is still discounting an oil price of $75 per barrel and trading at a large price-to-earnings premium to the market, with no earnings-per-share (EPS) growth expected in the next two to three years, and very poor dividend coverage. Even a recovery in prices that we expect wouldn't warrant these valuations.

Invest in the “unique” and best: Conglomerates don´t create value. Seek out innovative and competitive companies. M&A will happen but, as we have seen in the past, in the least expected, non-consensus names. Investors should keep in mind that consolidators look for scale, strong growth prospects, good footprints in sought-after acreage as well as new technologies in M&A candidates.

Debt matters: With the majors averaging net debt-to-equity of 31%–37%, optimistic dividend estimates and unachievable production growth targets pose real risks. In the case of independent exploration and production (E&P) companies, an average of 1.15x capex-to-cash-flow ratio might force companies to slow down if the focus is shifted to balance sheets and they see reduced shareholder interest. E&Ps have very large levels of debt, and the least efficient will likely find it difficult to recover lost valuation.

Service companies face lean years of lower margins and weaker backlog, and the sector cannot perform unless those two metrics improve. Consolidation, write-downs and retirement of old equipment are part of the cleanup process necessary to regain pricing power.
The International Energy Agency (IEA) estimates that the oil and gas industry will need to spend $23 trillion through 2035 to deliver the growth in production required to meet the world’s energy needs. Even assuming lower costs and more realistic demand, investments are unlikely to fall below the level, which should guarantee ample supply. The biggest mistake that the oil and gas industry can make is to believe that commodity prices need to or will return to peak levels. Once technology and innovation kick in, many projects undertaken in the past become sunk costs, companies become more efficient and old estimates of breakeven become irrelevant. Disruptive technologies are here to stay. The winners will be the most efficient, not the ones waiting for “the good old days.”

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