‘Unprecedented oversupply’ of natural gas coming this summer, says Marshall Adkins

EDITOR’S NOTE: Marshall Adkins leads the energy research team at Raymond James & Associates. His primary focus is on oilfield services and products. He has won a number of honors for his stock-picking abilities and is a three-time winner in the Wall Street Journal’s “Best on the Street” analyst survey. His experience includes 10 years in the oilfield services industry as a project manager, corporate financial analyst, sales manager, and engineer. Adkins holds a petroleum engineering degree and an MBA from the University of Texas. OGFJ’s Don Stowers recently caught up with him in his Houston office.

OIL & GAS FINANCIAL JOURNAL: You spoke a while back on the economy and where we might be heading at EnerCom’s Oil Service Conference in San Francisco. You were very frank and didn’t sugarcoat your opinions.

ADKINS: Well, Greg Barnett [EnerCom’s CEO] asked me to be the lead-off speaker, and I told him, you don’t want me to be the first guy up – it will put a damper on the whole event. I’m really bearish on the industry right now. But Greg said he wanted me to go ahead – that the industry people there needed to hear what I had to say. This was unfortunate timing for me because I’ve been bullish on the industry for most of my career. Now that I’m bearish, people that I thought were my friends don’t like me anymore.

OGFJ: I’m familiar with that sort of “kill the messenger” response. People don’t like to hear bad news. So, give us an update: how is business at Raymond James and what is your current outlook for the petroleum industry?

ADKINS: Well, that’s a hard question from my perspective because at Raymond James we’re actually doing fairly well. The parent company and our group here in Houston are all doing well. On a relative basis, we’ve gained substantial market share as some of the larger Wall Street firms have had their difficulties and a few companies have gone out of business. So, from a share perspective, the companies that weren’t over-levered have actually picked up market share. From a market share perspective, we’re doing pretty well. But, that said, the pie has shrunk dramatically in size. So the whole pie has been getting smaller, but Raymond James is getting a bigger portion of it. Here at Raymond James we haven’t seen a massive downturn in trading volumes and so forth, but obviously the industry is just a mess right now – both the financial side and the oil and gas business itself.

OGFJ: Do you see the oil and gas segment tracking that of the general economy? How likely it is that higher commodity prices will return and help the petroleum business recover from the downturn quicker than the economy as a whole?

ADKINS: Well, energy was holding up pretty well while the market was on its way down, but right now I think energy is suffering as much as any of the other segments with the credit crunch and commodity decline. So, for now, I think the overall economy is pulling the energy sector down. Demand for energy products has declined. But when I look long term, I think there will be a disconnect and the driver for that will be that global oil production peaked in 2008, and I think that as you scale back activity around the world, both because of low prices and the credit crunch, you going to see particularly the non-OPEC supply fall dramatically in 2010 and 2011. And so even if you don’t have a robust recovery demand, I think you’re going to see a pretty good recovery in oil prices. Gas…a tougher call.

OGFJ: Natural gas prices don’t necessarily parallel oil any more, do they?

ADKINS: No. In my mind, they are totally disconnected. Up until about three years ago, you could switch from crude to gas, at least here in the US. But, technically, I see no fundamental reason for that connection to exist. Psychologically though, the market still wants to believe they are linked, and so short-term, they will tend to move together on a day-to-day basis. But looking out over the longer term, I don’t see a reason for that linkage to remain.

OGFJ: Does LNG help contribute to a linkage between oil and gas prices?

ADKINS: Well, globally, yes. I think you will see them linked because as you build out the global infrastructure in LNG, oil and global natural gas, LNG, will be very substitutable between different countries. And so I do think there will be a global linkage – but not in the US.

OGFJ: When the dust has settled and the current

recession is behind us, who in the energy business will come out of this on top? Will it be the large integrated super majors, the state-owned companies, or others?

ADKINS: You really have to break it down almost more geographically and by commodity. We’ve been very concerned about natural gas, and I think that companies that are focused on natural gas are going to have difficulties, for sure in ‘09 and possibly in 2010, but it’s really too early to make that call. Globally, we’ve seen oil prices pull back, but I think they’re going to firm up, which seems to indicate that anyone who plays in the global oil market should do okay over the next two to three years.

So, generically, that’s how I would answer your question. However, beyond that, let’s look specifically at US. gas. The service companies are going to have a very rough ‘09 and an even rougher 2010 because you’re starting from a high base and you’re falling. So from an appearance and activity perspective, those guys have two very difficult years ahead of them – if they’re North American gas focused. But the things that are hurting oil services – lower drilling costs, lower everything costs – should help the E&P guys going into 2010. So you should see lower input costs. And there’s a chance you could see a rebound in gas, depending on how much supply gets whacked this year. And of course this depends on how much the economy comes back. So if you see gas prices come back in 2010, the E&P guys will do pretty well, but the gassy service guys will still have a rough 2010.

OGFJ: What is your view as to which regions in the US will be hardest hit? Rockies versus Gulf Coast, conventional versus unconventional gas, and so forth.

ADKINS: Historically, you had pipeline bottlenecks that really affected Rockies gas prices, particularly in the summer. And then you’d build new pipelines, and one year out of three you’d have parity in gas prices in the Rockies and, say, the Henry Hub. Last year we shut in maybe a bcf a day out of the Rockies for a couple of weeks, and the prices went sub a dollar. Our model right now shows that you’re going to have to shut in close to 10 bcf a day in the US, which is 15% to 20% of the US supply in ‘09. Well, that’s not going to happen, so that means that price pressures are going to back up – not just to the Rockies or the Mid-continent or the Barnett shale, where there are some pipeline constraints today, but I think it’s going to back up all the way to the Henry Hub and even into the LNG entry points because the LNG guys are telling us that with the new projects coming on globally, you’re going to see LNG flood in here this summer. My response to that is – it can’t. So the combination of all these things leads me to believe that the Rockies may not look a whole lot worse than the rest of the country, which will have a bigger problem than we’ve seen in the past.

OGFJ: Given what you’ve just said, why are gas storage facilities being built? Is this a good time to do this?

ADKINS: I think you’re going to see gas storage become extremely valuable over the coming years, particularly if we start to see any kind of rebound in demand. We have a phenomenal amount of supply out there, and the guys who can take advantage of the seasonal price differentials stand to make a lot of money. So the answer is yes; gas storage operators probably will do very well.

OGFJ: Earlier this year, capital for the oil patch had virtually dried up. Has this situation changed in the past few months?

ADKINS: Banks are still holding back somewhat. That doesn’t mean that there isn’t capital available. The capital markets have been open. You’re seeing debt deals get done, again on the capital market side, not on the banking side. You’re seeing some equity deals get done. You’ve had substantial money raised on the equity side, particularly the MLP side. People want the yield, and evaluations today are attractive enough to encourage them to buy into that.

OGFJ: Is this mostly by midstream companies or E&P companies?

ADKINS: So far, mostly midstream, but we’ve seen Whiting Petroleum and one other E&P company go out and raise equity. So it’s both midstream and upstream, but the easier ones are the pipeline deals where you’ve usually got a pretty good stream of cash flow coming in and investors say okay.

So there is capital, but the banking system so far seems to still be pulling in its horns as a result of what’s happened overall in the past eight or nine months. What is interesting is that the banks seem to be retrenching into their core set of loans and customers because they can still borrow at ridiculously low rates, and they lend it back out at pretty good rates. So the returns have been phenomenal, particularly if they’re buying debt in companies that they are already financing. Or debt that other other banks are selling, saying, here I need to get it off my balance sheet, so I’ll sell it to you for 80 cents on the dollar. So my view is that the banks are slowly transitioning and the returns there ought to be pretty good.

OGFJ: Will there be a real shake out if this industry downturn lasts longer than a year or so? Do you expect to see a lot of asset sales and mergers?

ADKINS: We’re not anywhere near that point yet, but you’re going to put a lot of strain on balance sheets. Right now, a lot of the service companies still have pretty good balance sheets. The E&P companies, not quite as good. If conditions haven’t changed much a year from now, I would expect to see quite a bit more asset sales. But I have to stress that we’re not to that point yet. The pain is still manageable because everyone is still in shock right now.

OGFJ: Under this scenario, who will be divesting and who will be acquiring assets?

ADKINS: Obviously the majors are still cash rich, so they will be the acquiring companies. Whether it will be in North America – gas-centric companies, or globally, I don’t know. I still think this is too early to call. So far the majors haven’t shown a huge appetite for that. Their participation so far seems to be more of dealing with a learning curve. The attitude seems to be – let’s see what they are doing in the Haynesville so we can take it to Europe. But you know this [acquisitions] is coming. The balance sheets for many of these [super majors] are bigger than most countries. They obviously can afford to do it, but it remains to be seen how aggressive they will be in doing it. If history is a guide, I’d say probably not real aggressive.

OGFJ: You’ve been following the oil services sector very closely for a number of years. How will they survive the downturn? Will they come out worse or better than the E&P firms?

ADKINS: In the up cycles, the service companies always do better because they’re effectively a second derivative play. And in a down cycle, they always do worse for the same reason. This is true both from an earnings and a stock price performance perspective. In the current environment, they have underperformed, and they probably will continue to underperform until we see a bottom in the fundamentals, which could happen very easily in the next six months. Services are going to have a very tough environment ahead of them for the next six to 12 months.

OGFJ: How would you compare the impact of the current downturn on offshore versus onshore?

ADKINS: It all boils down to oil versus gas in my opinion. Clearly the offshore, oily deepwater guys are doing very well compared to their North American gas-centric counterparts. So, yes, in terms of earnings, the deepwater drillers, the deepwater manufacturers and parts suppliers are doing better than the onshore companies, which tend to be gas centric. Secondarily, deepwater long-term projects are performing better than shallow short-term projects on the shelf. The reason is that deepwater projects tend to be long-term, five-year projects that are not going to be cancelled. Gas projects tend to be in the shallow waters, and they can be turned on and off pretty quickly.

OGFJ: Let me ask you to speculate. Do you see crude and natural gas prices going up enough this year to make a difference in project economics?

ADKINS: Well first, let’s separate out into crude versus gas. Gas – no. We have too big of a problem both in terms of supply and demand. Everyone pretty much knew by early 2008 that with all the shale gas coming on stream, we were going to have a supply problem. What was not evident at all was the demand problem. Either one is a big enough problem to cause gas prices to fall, but now we’ve layered on an economy-driven demand problem. This summer that’s going to create an unprecedented oversupply of gas. The way you solve that is to take the rig count down, let the decline rates kick in, and have supply fall enough to counteract and rebalance. That’s going to happen, but it’s going to take some time. Certainly the average gas price for the year is going to be pretty ugly. As far as recovery in 2010 is concerned, the jury is still out. I talk to a lot of really smart people, and there doesn’t seem to be a consensus yet on any direction on the global economy. An economic recovery in 2010 is critical to the performance of the industry. If the economy doesn’t perform better, I’m not sure we do get a bounce in gas prices.

Crude is almost just the opposite. Short term, very difficult to determine. It all hinges on global demand and OPEC’s ability to cut production. By the way, OPEC has done much better than any of us felt like they would do. So those are wild cards that, short term, could lead crude anywhere. Plus, some of the other wild cards would be geopolitical events, such as wars and acts of terrorism. These events could turn prices on a dime. Longer term though, I’m very confident in crude. Crude supplies are going to fall, and the economy will rebound and new demand will kick in at about the same time that supplies are falling. So when I look at crude in two, three, or four years, I think prices will be meaningfully higher. In the next six months, who knows? My gut says it’s probably going to drift higher, but my confidence level in that is very low.

OGFJ: Some people think a lot of the price volatility is due to speculative trading that artificially inflates or deflates commodity prices. What are your thoughts on this?

ADKINS: You’re right, there was a big brouhaha over the speculation issue. Speculation is always bad when it’s driving crude to $150, right? So that’s when they’re going to drag oil executives before Congress and they’re going to say prices are high because of the speculators. Well, speculators are part of an efficient market. What was not told as we were trying to blame all of this on the speculators was that underlying the price move were very strong fundamentals. We were seeing a peaking of supply, and we were seeing demand outstripping supply, and that was compounded by a flow of funds into the commodities arena, especially because there weren’t good investment alternatives elsewhere. But that’s how the markets work. People want to generate a good return. What I would say about the speculators is – if they are wrong, there is always someone who will take the other side of that bet. And prices will correct. Speculators can drive things out of whack for a little while, but that is not why oil went up over the last two years. And it is not why prices dropped so rapidly in the second half of the year. It was because of market fundamentals.

OGFJ: In your view, did high commodity prices contribute significantly to the recession, or was it the opposite? Was it the recession that caused commodity prices to go down dramatically? Which was the cause and which was the effect?

ADKINS: That’s a great question. If you go back historically and look at every major recession over the past 40 or 50 years plus, what you see is that before each one, energy prices were moving up. It was a significant driver in the early 1980s recession. We had two years of rising oil prices, and finally the market said enough. Inflation was going berserk. In that case, oil was definitely a contributor to the recession. If you go back to the 1974 recession, oil prices had also spiked. But there were underlying structural problems with the market before that. So it was a little bit of both.

If you look at the current recession, oil was part of a trigger and it exposed greater fundamental problems that were already there, such as housing and the over-leveraged financial system. Oil was a modest driver, but it was not the main cause of what was going on. As evidence of that, you can see from its peak, oil prices have dropped 75%, and gas is down from $14 to $4. And, guess what – you’re not seeing demand pick up. So clearly there were other issues that were the primary drivers.

OGFJ: On the banking and financial side, it appears the government plans to tighten up oversight of the financial services sector because it is widely believed that lack of regulation got us into this mess. Is this a good thing?

ADKINS: Well, I think the government sees this as their job. There will be more oversight and regulation because they want to fix whatever they think didn’t work properly before. But frankly I think a lot of those things are going to take a back seat right now because there are bigger problems to tackle. By the time this recession is over, the amount of wealth destruction in the US will be between $30 trillion and $40 trillion, and you can’t fix these problems with $2 trillion to $3 trillion in stimulus funds. It’s going to take some time to overcome that.

OGFJ: The US, regardless of whether we have a Democrat or a Republican in the White House, pays lip service to the idea of our country becoming less dependent on imported oil. Yet no one has come up with a coherent energy policy that addresses this issue. Why is this?

ADKINS: Because it’s damn expensive. Americans want it all. We’ll accept oil imports if it means cheap gasoline. We may say we want energy independence, but we don’t if it means paying $10 a gallon for fuel at the pump. That’s why the free market is beautiful because eventually it will force us to go there. When prices get high enough, we’ll decide that solar or wind or a hybrid car is not such a bad idea. When fuel prices are as cheap as they are in the US, we don’t need alternatives that much. I don’t think it’s a bad idea to push those initiatives forward via the government and certainly that’s what Europe has done. But they’re paying four times as much for gasoline as we are.

OGFJ: Last question. What does the industry have to do to convince states and the federal government to allow drilling in places where it is prohibited now?

ADKINS: Several years ago, I was giving a speech in Florida, which has been vocal in opposing offshore drilling. At the time, they wanted to prohibit any drilling closer than 150 miles from the coast because they were concerned it would hurt the tourism business and the drilling rigs would be visual pollution compared to their pristine beaches. I pointed out that you could go to the top of a tall hotel on the beach and the farthest you could see would be about 10 to 12 miles tops. So that takes care of the visual pollution argument. The industry would not be drilling that close to land. In addition, most of the wells will be gas wells – not oil. The chance of leakage from these wells is so small as to be almost negligible, but if the gas did leak out, it would be in the form of bubbles. Ironically, some of the states that formerly opposed drilling are starting to come around. We are seeing some of them push this because they see the benefits and want their piece of the pie.

OGFJ: Thanks for taking time out of your schedule to talk with us, Marshall.