With oil prices recently drifting lower, companies in the
Canadian oil and gas exploration and production (E&P) business have seen
significant share price declines. Some of the more marginal names in the space have even seen precipitous share price drops
of 50% or more. While I don’t think the
bottom is in quite yet for the sector, the risks of
shorting the E&Ps at this point may not justify the potential
rewards. On the other hand, oil services companies are showing signs of weakness, which I believe will continue.
The thesis is as follows:
The three primary sources of capital for oil and gas E&Ps are equity, debt, and joint ventures. All of these sources of financing are likely to become more
difficult to secure if oil prices continue to decline.
Lower share prices
make equity financing unattractive
Falling share prices make equity a more expensive way to raise capital as more
shares need to be issued to raise the same amount of cash. And while a high cost of equity does not always
stop determined companies from raising money in the equity markets, it does
limit the amount of capital that can be raised through share issuance.
Lower oil prices
limit growth in credit lines
The oil and gas business is risky, and banks are usually
unwilling to lend money to risky businesses without hard collateral. In the E&P business, this collateral
usually takes the form of oil and gas reserves. The value of those reserves fluctuates with
the price of oil and gas, and when prices are falling banks are more reluctant
to extend loans. Credit growth will therefore be limited.
Joint Venture
financing may have peaked in 2012
The JV capital that has sustained much of the industry over
the past few years will also be harder to come by as the Asian national
oil companies (NOCs) that have driven recent JV activity already claimed their
stakes. Many of these NOCs were also
willing to pay a premium to acquire technology and experience with
unconventional oil and gas. It is unlikely that future JV agreements will be
as favorable to the Canadian E&P industry as this strategic technology premium falls off.
A larger share of
future CAPEX will need to be internally funded
All of these factors will make financing exceedingly
difficult for E&Ps in the near future, assuming oil prices continue to
grind lower. This means the industry
will be forced to live within its cash flows – something it hasn’t had to do
for a very long time. Many companies
have already started to make the transition to lower, internally driven CAPEX,
but the big adjustment is yet to come. I
ran some numbers and found that the E&P sector is outspending operating cash
flow by 10-15%. This is before paying
dividends or buying back shares!
Lower E&P CAPEX =
Lower service industry revenue
The implications to the service industry are dire. If E&Ps are forced to reign in spending
by 10-15% (or more assuming they want to continue paying dividends or rebuild
stretched balance sheets), we can expect revenue to the service industry to
drop by at least that much. Due to the
asset heavy nature of the services industry, where small changes in utilization
rates lead to massive swings in earnings, we could see these earnings at these companies get
crushed.
I don’t think share prices of service companies are
adequately pricing in this risk. While
these companies may look cheap on a yield or P/E basis, they are
classic value traps. Earnings are a
trailing measure - if you believe oil prices will drop, these companies are
going to be money losers over the next few years. And if you don’t, you are better off in the
E&Ps, which look even cheaper by the same metrics.
Conclusions
If the thesis is correct, it sets up a fairly low risk trade
– go long select E&Ps, and get short service companies. If oil prices recover, the E&Ps will
bounce back, limiting your downside risk on the trade. If oil prices continue to drop, the E&Ps
will get hit hard, but the service companies will be decimated.
Recommendations: Short FRC.TO, CFW.TO, TRW.TO, PD.TO. Risk averse investors may want to pair with a
long position in high quality E&Ps.
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