GUILD INVESTMENT MANAGEMENT BELIEVES OIL PRICES CAN GO HIGHER, BUT PRODUCER DISCIPLINE IS REQUIRED
OIL & GAS FINANCIAL JOURNAL: The collapse of oil prices since last year has sent a shudder throughout the industry. Recent reports have concluded that approximately $1.3 trillion dollars in value has been lost since the pullback began last year. Do you believe that the industry is in a prolonged state of low commodity prices?
ANTHONY DANAHER: The shudder has been felt in many sectors around the globe; it has not been confined to oil and gas. Overall, the global commodity complex is struggling with overcapacity and excess supply.
Oil is better positioned to recover than say base metals and many other commodities, as oil remains the lifeblood of global economic activity. If global economic activity picks up, excess oil supplies can disappear quickly. The same can't really be said for some other industrial commodities.
The first half of August brought a relentless decline, and prices can go lower, driven by fear of deflation, Iranian crude hitting the market, Chinese economic data, short sellers piling on, and/or panic hedging by producers who need to secure cash flows. But these are short-term factors.
On the plus side of the ledger, these low oil prices are economically stimulative around much of the world. Longer term, we do see signs of a recovery in price. Global oil demand is still growing about 1.5 million barrels per day. At the same time, falling investment in exploration and the natural decline curves will help reduce excessive North American supplies.
Outside the United States, many of the world's producers, whether they be private or government, need considerably higher prices to cover their expenditures. Will oil prices head back to triple digits? Not without significant help from geopolitics, but they certainly can go to the $60 to $80 area, which is the price range many feel justifies additional E&P activity and investment in North America. Oil could go even higher if the US dollar cooperates by declining from its high perch.
OGFJ: Despite the pullback in commodity prices, more than several oil producers have reported record production volumes in the second quarter. If exploration and production companies continue to produce record volumes in order to increase revenues and offset reduced commodity prices, what is the likelihood of a near-term recovery in prices?
DANAHER: Declining North American production is coming - you just didn't see it in the second-quarter reports. The Q2 production increases are partly a result of money that was committed to some time ago. Stopping projects is difficult, especially if you have hedged the expected barrels at higher prices. It is the money that is not being spent today that will lead to coming quarters' production declines, which will eventually create a better supply/demand situation.
Additionally, the industry is a victim of its own success. Technological efficiencies are keeping production stubbornly high. The US has some very good companies, with very good rock, that have rapidly improved their operational efficiencies. Completion optimizations, pad drilling, and the rapid decline service costs have dramatically brought down the breakeven prices for many North American producers. Below $50, many companies are still incentivized to go out and complete wells.
Certain operators will still produce as long as positive cash flow can be achieved and will accept low IRRs. Companies that need cash are having to up the barrels in order to make up for lower prices. They are, perhaps, hoping they can outlast the oversupply situation even though their actions are lengthening the oversupply environment for everyone.
OGFJ: Earlier this year, a number of different energy companies successfully raised capital via the equity markets. Investors who participated in those offerings have watched the value of those investments decline; in some cases significantly decline. What was the market missing at that time? Do you believe shares have bottomed?
DANAHER: Looking back at earlier this year, bargain hunting investors in the spring allowed oil companies to raise billions in equity and debt. In March, their shares had fallen hard and looked washed out. The dollar rally stalled, and oil companies were convincing in their presentations talking about increased efficiencies, disciplined operations, and strong reserve growth.
When investors saw oil prices bounce off $43 in March, many thought this was their chance to get into the stocks at bargain basement prices. They were also betting that the global price would recover to a $60-plus to $80-plus per barrel "equilibrium price." It did for a week or so, but the Saudis, Iraqis, and Iranians did not cooperate - not to mention global economic growth hasn't really picked up. In the summer months, shares have cratered, and many of those March buys are under water. Companies may be challenged to sell debt and equity in the near future. Some company shares look like they may have bottomed, but sadly, some companies' shares may be still headed toward zero.
Ultimately, however, global economic growth, the effect of a rising or falling US dollar on the prices of all commodities, and producer discipline (for example OPEC producing about 2 million barrels per day over their stated quota) will ultimately determine if the commodity prices have bottomed.
OGFJ: Many hedge funds move quickly in and out of the market, but your firm takes a longer-term approach toward investing. Talk to us about how Guild Investment Management views the current downturn. Are current valuations creating strong buying opportunities for long-term investors?
DANAHER: At Guild Investment Management, we primarily manage private accounts. Led by Monty Guild, the firm's founder, our in-house analysts, and a worldwide network of experienced investors, we are always looking for investment opportunities that offer growth, value, and dividends. We are global in scope, and look for longer-term trends and themes in which to guide our investments. Our flexibility allows us to concentrate in a sector or to step away when an industry, country, or sector is not rewarding our clients.
We have an investing discipline in place where we cut losses at a predetermined point when an investment is not working. We do like to look for longer term ideas, but when a group is falling as fast as the energy sector has since Q3 2014, our investment discipline keeps us from holding onto positions. We have bought energy shares a few times over the past year, but the sector's steep decline kept us from concentrating or becoming attached. This is an investment discipline that has helped us over the decades.
We always like to come back to energy. The sector is a major driver of activity in the global and US economies. Even when we do not have many significant positions in energy, we are always paying attention to companies and looking for long opportunities. This is another investment discipline that has helped us over the decades.
We definitely see values emerging after this summer's decline. There are a lot of companies that could prove to be excellent long-term positions. Remember though, even the longest-term minded energy investors, the energy-focused funds, have to shorten their time horizons when met with redemptions from investors. We find the forced selling from liquidations creates opportunity.
OGFJ: While public valuations have pulled back significantly, we've seen very little on the M&A front. Do you anticipate an uptick in M&A activity as we look toward the back half of 2015 and into 2016? What factors might trigger an increase in M&A activity?
DANAHER: Oil and gas M&A will again be a big theme. Majors and large independents that may have been struggling to grow will be able to buy assets from smaller companies for a lot cheaper valuations than just a few months ago. Corporate CEOs have been waiting for more clarity on the commodity prices. After a few high profile, ill-timed (in hindsight) deals, the acquirers with deeper pockets are saying "What's the rush?"
Also, there are bound to be some forced dispositions of assets before, during, or after this autumn's bank line redeterminations. Bank lines will certainly be drawn in for some companies, and deal activity could get exciting.
Lastly, companies that have been holding off hedging future production did not get the higher prices they were hoping for. Now they have some tough decisions in front of them. Their higher priced hedges have run off, and they see cash flow is getting stressed. Cash-strapped companies will need to do something. So, yes, we do see consolidation on the horizon.
OGFJ: Which companies are best positioned to emerge from the current downturn?
DANAHER: While many smaller E&P companies have seen bigger percentage stock price declines and may have more upside, we are focusing on companies with financial flexibility. Balance sheet strength is key. Per share growth, operational efficiencies, good rock, and access to takeaway capacity are also keys. Remember, infrastructure investment is also slowing dramatically, so companies that do not already have access to pipelines may never get it.
When the sector turns, the larger faster-growing oil producers will be among the first to move. While they may not be the cheapest, they will get a lot of investor dollars. We also see some smaller operators in the US and in Canada that have unique characteristics, strong per share metrics, and advantages that make them attractive. We are busy talking to company managements and working on our list of what we want to own for the recovery that is coming.
OGFJ: The industry has announced more than 150,000 layoffs since last year, with some believing more layoffs could soon follow. That said, is the industry setting itself up for another "lost generation" of oil and gas professionals as college students and young professionals look toward other more stable careers?
DANAHER: It's a shame, but it happens in a many industries from time to time. A lot of these people may have come to the oil patch from other fields looking for good salaries and stock options, but perhaps they shouldn't have been expecting long-term job stability from this sector. Prior to the shale oil boom, a lot of these same people may have been in engineering, construction, or some other business. Those with the right mix of willingness and ability will always land on their feet.
OGFJ: All eyes are on the Federal Reserve's upcoming meeting. Many analysts believe that a rise in interest rates, even if small, is in order. Do you believe that the oil markets have factored in an increase in rates? If not, what is the potential downside for oil prices?
DANAHER: Even if the Fed raises rates in the near future, rates will still be very low by historical standards. A couple of quarter point rate increases is not likely to derail the economy. That being said, rising interest rates adversely affect anybody who uses a lot of debt, which goes back to our preference for balance sheet strength when we look at companies.
If interest rates do go up a lot, it will probably be accompanied by higher economic activity and higher inflation, which is good. The sector would prefer a growth environment with higher rates to one with low interest rates, a stagnant economy, and persisting deflationary pressures.
In short, we don't see one or two rate increases as a big negative for the energy sector.
OGFJ: LNG shipments at Cheniere Energy's Corpus Christi plant are now nearing a reality. While the initial shipments will represent a small fraction of total US natural gas production, it does open the door toward new demand mechanisms in the sector. What, if any, impact do you think this will have on natural gas prices?
DANAHER: Natural gas will remain plentiful, and technology keeps improving recoveries. A very cold winter and a very hot summer can help prices periodically, but the reality is that the persistently low natural gas prices are a function of companies willing to accept lower IRRs. As long as companies in the Marcellus, Utica, and Texas basins keep talking about being profitable at less than $2 per mcf, then gas supplies will stay high. We have met with many companies over the past five years that are proud of their ability to weather very low prices. LNG exports will have a modest impact on psychology, but not necessarily prices. LNG exports are a marginal positive, but that doesn't change the equation meaningfully.
OGFJ: The US House of Representatives is expected to vote as early as this month to lift the ban on oil exports, with Senate action anticipated early next year. If successful, how might this change impact oil prices?
DANAHER: Oil is a global commodity that already flows pretty freely around the planet. However, a final decision on US exports helps remove an uncertainty. Removing uncertainties is rarely damaging to company valuations.
Conventional wisdom would suggest that the Brent-WTI spread should narrow, and that is an overall bullish development for US oil producers, and a negative for US downstream refiners. We believe the impact may be more nuanced.
Opportunities will be created, but there will be uneven effects on companies and market dynamics based on location and crude types. Certain PADD storage areas will be helped, others hurt. Sure, crack spreads will move, but certain downstream players will feel it more than others.
OGFJ: Is there anything else you would like to add?
DANAHER: First of all, we are monitoring the US dollar, and we are cognizant that a resumption of the strong US dollar trend is a headwind for the entire energy complex.
We are looking for opportunities in oil and gas E&P, in downstream, in infrastructure, and in energy-related services and technologies. Discipline is what we want to have as investors, and discipline is what we are looking for in our investment candidate companies.
We do our research with the idea that we want to own investments for the longer term. As investors for the past four-plus decades, we know markets get overdone on the upside and overdone on the downside. August 2015 in oil and gas looks like the latter.
OGFJ: Thanks very much for talking with us.
Anthony Andora, Edge Consulting Solutions, contributed to this article. Executive photos by Brian Gove.