Is This Oil Price “The Big Gap” for Investors?
I think investors are in the middle of a Big Gap in oil stocks. The Leaders have already run so hard they’re pricing in $75-$80 oil–so there’s not much value or leverage there. But the Laggards need even higher oil prices than that to really work–$90-$100.
Their assets don’t pay out quite as fast, or their debt levels are high enough they really can’t afford to grow at these oil prices–or even at $70 oil, without regular increases in debt or new dilutive equity. Do I really want to own them–even for a trade in this volatile energy market?
It’s a conundrum. Do I put my money into this Big Gap–buying the Tier 2 stocks and hope oil goes higher? (And let’s just forget that even the best US junior/intermediate producers are about 30% natural gas, which is slowly falling out of bed right now).
Earlier in 2015 I did buy a couple leading junior producers, and one service company but the charts say I didn’t buy enough. Those stocks ran hard–in fact, so hard I see leading stocks on both sides of the 49th parallel at or even above their highs of a year ago–when oil was $100! And most of these stocks have even diluted. As a result, valuations have stretched from 9x cash flow to now 15-17x for a few companies, on really good days. Whoda thunk that only three months ago?
My original investment theory in 2015 was that US production would stay a little bit stronger for a little bit longer than the Street expected–despite the drop in rig counts. That was certainly what happened in natural gas after the bottom in April 2012. And the main way to play that thesis is to invest in refineries–stronger production creating oil prices weak enough to stimulate stronger gasoline demand and prices. Refiners earn the spread between oil and gasoline prices.
So I bought more refinery stocks than producers. I’m flat to up on those trades, and I’ve taken some profits. But now it’s clear the Street is increasingly confident that US oil production is peaking right here, in March-April, and a definitive—even if shallow–production decline will start to happen 2-3 months sooner (mid-late Q2) than the Street thought it would in February (back then the thinking was mid-late Q3).
The two factors that surprised the Street in Q1 was the pace of rig drops (consensus was we would rarely see over 50 a week and we saw a month of 90 rigs drop per week) and that oil demand was inelastic to price. Last fall there was lots of statistically-backed-up-stories saying oil demand did not increase as prices drop. But by late January the demand stats were pretty clear—a BIG jump in US demand, much faster than the Street expected. (So that part of my refinery idea worked out…). And now investors are seeing Asian demand numbers up as well.
All that data started to change psychology last week, and finally the Tier 2 oil stocks started showing some life. But I’m still feeling shy about deploying capital into the Tier 2 producers–because they need even higher oil prices to just survive. And I’m just not confident the Market is going to see oil prices move that high.
I see the leaders like EOG saying that with reduced costs from the OFS–OilField Services–and other cost-cutting measures, $70/barrel is the new $90 (meaning their cash flow and profitability will be the same at $70 oil as it was a year ago when oil was at $90/barrel).
The problem is, even at $90 oil there wasn’t a lot of positive cash flow out of the shale plays (again–most have BIG gas weightings). For most of them, that was because they were just growing too fast. Now, EOG has the size and the team to make $70 oil work. But most (almost all?) junior and intermediate producers don’t work at that prices. When I say a company “works”, I mean it can grow 10%-plus from its own cash flow.
For a junior producer–and even for most intermediate sized companies–they need wells to pay out in 1 year to even grow at 15% organically. That wasn’t an issue before last fall because debt and equity were easy. But for the Tier 2 players, that’s still not easy (though it’s not as hard as I would have thought!).
Most leading companies are now struggling to show in their powerpoints that they can get down to two year payouts with a new mix of lower pricing and lower costs, and sometimes as low as 1.5 years. But even that means a very low organic growth rate–if not just keeping production flat. I am seeing powerpoints talking about 4 year payouts. That for sure doesn’t work.
The Leaders were able to finance in Q1 and all of those financings are up, as oil prices are up. So they have some breathing room.
But the stock prices of Tier 2 companies who were much more reliant on equity infusions to stay alive during the bull market—or are just too small in low margin environment—are still down a lot (though up to 50% off their January lows). In Canada that’s companies like Long Run (LRE-TSX) or Crew Energy (CR-TSX) and in the US the baby-Bakkens like Emerald Oil (EOX-NYSE) and American Eagle (AMZG-NASD). There are many others.
That’s what I call The Big Gap–oil prices have recovered enough that the Street is willing to back Tier 1 producers; those with proven teams and low break-even costs. But with Tier 2 stocks so far behind–what all this is telling me is that the Street’s consensus is for higher oil prices, but not high enough that a rising tide will lift all boats.
Emotion could take the Tier 2 stocks higher but quarterly cash flow will be a big reality check for investors on most juniors and intermediates–even at $70 oil.
That fits into my $65-$70/barrel oil thesis—where the best producers and guys with size can make production profitable—but not the little guy or the inefficient guy.
If that theory gains credence through weekly Wednesday EIA numbers, it will be interesting to see how excited the Street gets and how much they start to move up the leading stocks—with all of them already pricing in $75-plus oil—or if the Tier 2 stocks get on a roll.
I would be biased towards Canadian (vs US) Tier 2 stocks now for a couple reasons.
I don’t see $65 oil improving the Canadian dollar much, so Canadian producers should enjoy some better pricing—if WTI does go to $65, that puts Canadian production very close to CAD$80/barrel–and makes decent cash flow for producers with big oil weightings. I don’t see a larger drop for the Canadian dollar now that oil has, IMHO, put in a low. That adds a currency bonus to the trades.
Also important to note that Canadian differentials (discounts) for both heavy and light oil are very tight now, and are expected to stay tight—meaning the price difference for Canadian oil is now low; it’s very close to WTI (on a historical basis).
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