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  • Writer's pictureEric Cinnamond

Locking It In

<November 6, 2020>

After dropping my kids off at school last week, I noticed a gas station promoting $1.75 gasoline. “Wow,” I thought, “that is an incredible deal!” I quickly made a U-turn and filled up my tank.

As I drove home, I thought more about the current price of gasoline and oil. Considering we follow several energy exploration and production companies (E&Ps), I was well aware of the pain these businesses were enduring. As spending on drilling and well completions has plummeted, I also knew how much the energy service sector was struggling. The ancillary businesses that serve the E&P and energy service companies were also losing revenue. So, while I was thrilled to be buying gas at $1.75, I knew many companies, workers, and families were facing significant financial hardship.

Fortunately, it’s not all bad news for the energy sector. For the first time since I’ve been following the industry (27 years), its leaders have made significant, and in our opinion, constructive changes to their business strategy. No longer are energy executives chasing aggressive production targets and overvalued acreage. Instead, energy companies have become disciplined and pragmatic, funding investments with internally generated cash flow. Debt reduction and achieving adequate returns on capital are also now in favor. The industry’s recent commitment to generating free cash flow and reducing financial risk is something we thought we’d never see. We find it refreshing and encouraging.

The energy industry’s abrupt shift from big spenders to responsible capital allocators did not come from within. It was forced upon the industry by the free markets and capitalism. After years of egregious misallocations of capital and write-offs, investors and bankers finally said enough is enough. If energy companies wanted capital, they’d have to generate it themselves. The days of unlimited debt issuance, well-received equity offerings, and generous bank credit lines were over.

The desire by banks to reduce their energy exposure has been noticeable. From Cullen/Frost Bankers (CFR) Q3 conference call, “Energy loans continue to decline as a percentage of our portfolio falling to the end of the third quarter. As a reminder, the peak was 16% back in 2015. Oil prices have stabilized from volatile levels that we saw earlier in the year and we continue to moderate our company's exposure to the energy segment.”

The bond market has pulled back as well. Even as corporate debt issuance has soared in recent months, it’s been challenging for energy companies to issue bonds on favorable terms. In fact, as maturity walls approach, many energy firms have been unable to refinance their debt and have been forced into bankruptcy. According to Haynes & Boone, 40 E&P companies with $53.7 billion in debt have filed for bankruptcy in 2020.

In an attempt to survive, many energy companies are minimizing capital expenditures in order to generate the necessary free cash flow to reduce debt. SM Energy discussed this strategy in its Q3 conference call, “We've talked about the things we're focused on, which is free cash flow generation, absolute debt reduction and leverage.” SM Energy’s capital expenditures were 40% below DD&A (depreciation, depletion and amortization) in the third quarter. Its underinvestment aided free cash flow, which allowed the company to purchase $91 million in face value of its bonds for $66 million. Since the bonds were purchased at a discount to their par value, SM Energy recorded a $25 million gain on the extinguishment of its debt. These are not capital allocation decisions we normally see from energy companies. Again, we are very encouraged.

As investors and bankers starve the energy industry of capital, energy companies are shrinking. Reserves are being depleted, equipment is being retired, and employees are being laid off. While the resulting pain is real, it is a necessary function of capitalism and free markets. And it’s one of the things we appreciate about the energy industry and energy markets. With so much interference in the broader financial markets, energy remains relatively uncontaminated from central bank intervention and government bailouts. Energy prices continue to fluctuate based on supply and demand; just as free markets were intended to function. Left on their own to survive, many energy companies are being allowed to fail and restructure. As Wall Street eagerly waits for its next multi-trillion dollar stimulus plan, the energy industry endures and, in our opinion, will eventually benefit from the natural cleansing process of capitalism.

As energy prices and energy stocks remain depressed, investors are eager to know when the industry will rebound. Based on recent earnings reports and conference calls, some industry leaders believe the bottom has been reached. That said, few are predicting a meaningful recovery in 2021—only flat to slight growth as E&P companies reset their annual capital budgets.

Regardless of how long the current downturn lasts, we believe current oil prices are unsustainable as they trade below the breakeven price of most major producers. In the chart below, we list the breakeven prices of U.S. shale regions, Russia, and Saudi Arabia. For Russia and Saudi Arabia, we use their fiscal breakeven price, which the EIA defines as the minimum price a country needs for its government to meet its spending outlays and balance its budget.

Although it’s difficult to predict when energy prices will rebound, we believe the industry’s response is setting the stage for its next bull market. As energy companies are deprived of capital and lay down their rigs, the number of wells being drilled has plummeted. With drilled wells in freefall, we expect U.S. oil production and inventory to continue to decline, resulting in an improving supply and price outlook. And while waiting for the energy cycle to turn requires patience, the longer prices remain depressed, the more future production declines and, ultimately, the greater the rewards for those that persevere.

Central bankers often view falling prices, or deflation, negatively. They argue deflation harms economic activity as consumers delay purchases and wait for even lower prices. As it relates to energy, we disagree. We believe declining energy prices have been positive for the industry, forcing its executives and board members to manage capital more carefully and efficiently. And as it relates to deflation reducing demand, we also disagree. At $1.75 a gallon, we believe current gasoline prices are unsustainable as they require oil to be produced at prices below the cost of production. Therefore, we want to buy more gasoline at today’s prices, not less. In fact, after filling up my tank last week, I went home and estimated how much our family will spend on gasoline over the next five years. With that amount, I purchased energy stocks with strong balance sheets. Instead of waiting for even lower prices, I want to lock it in!

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Oil breakeven: For a country it is the fiscal breakeven or the minimum price that a country needs to receive per barrel of crude oil sold for its government to meet its immediate spending needs and balance its budget. Breakeven for a region is the price oil companies within the region would need to breakeven on new wells.

EIA: U.S. Energy Information Administration.

West Texas Intermediate (WTI): a specific grade of crude oil and one of the main three benchmarks in oil pricing. WTI is known as a light sweet oil.

Free cash flow: Cash generated from a business’s operations minus capital expenditures.

Par Value: The face value of a bond that determines what will be paid back at maturity.

Maturity wall: The period in which many existing debt arrangements come due or approach maturity.


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