The Energy Report: Oil prices continued to fall last month. What happened? Is this a problem of too much shale oil, too little demand from China or something else entirely?
Keith Schaefer: I think it has a lot to do with increasing shale production in the U.S. Production resiliency has surprised everyone. It surprised investors and lenders. It certainly surprised the Saudis. And it surprised the long oil speculators. We saw that nice pop back up to $60 a barrel ($60/bbl) after the initial collapse to $40/bbl in December/January. But as the rig count dropped and oil production failed to decrease, the longs have gotten discouraged.
The Street has realized that the Saudis are going to keep putting the pedal to the metal, Canadian heavy oil production cannot be turned off, and debt-laden producers in the States aren't going to shut down existing production. We will continue to have excess supply for the foreseeable future.
TER: If rig counts are not a good indicator of future production, what signs will signal we are headed for a move up to sustainable prices?
KS: Rig counts have not been an indicator yet. Producers just keep finding new efficiencies, new technologies, new savings on service costs that allow them to continue pulling oil and gas out of the ground. The market has lost confidence in the U.S. Energy Information Administration (EIA) and the Paris-based International Energy Administration. Those numbers don't carry the weight they used to carry. In the end, we might just be waiting for time and recounts. [Note: Since this interview was conducted, the EIA has come out with a new methodology for oil production reporting, and revised production in the U.S. downward by 100,000 barrels per day (bbl/d).]
TER: That explains the uncertainty on the supply side. What factors are impacting oil prices on the demand side? Chinese market news? The looming Federal Reserve interest rate increase? What are you watching to determine when that excess production could be absorbed?
KS: Higher interest rates would put some discipline into this oil bucket. The main reason oil prices are so low is because of the zero-interest policy. This industry lives and dies on debt. If debt was all of a sudden 6–8% and the banks were firm on their covenants, there's no way the U.S. would have had anywhere near the growth in production we've seen. But when debt is free and you have the U.S. dollar as a carry to boot, it's basically free production.
"Royal Dutch Shell Plc sees today as the bottom that sets it up for success at the top of the next cycle."
So, yes, I am watching interest rates, although I don't know that a nudge from essentially zero to 3% is going to make much difference. I think interest rates would have to rise to at least 5% before you see debt get reined in and the lenders get a lot more disciplined with the producers.
TER: You have been writing about the profit margins in the refiners. Is that a safe way to weather this storm?
KS: It was up until recently. We've seen a stunning pullback in the crack spread in the last 10 days, down about 40% from where it was in January. We sold out of our Valero Energy Corp. (VLO:NYSE) position for a very small loss just to sit and wait out the volatility. Gasoline inventories have been up, and prices have taken it on the chin hard. I still own refineries as my biggest position in the energy sector. My two largest positions are the refinery trade and cash, and cash dwarfs the refinery trade. I'm waiting for some new trend to develop that we can start to play. I know it's hard for retail investors. Often the hardest thing to do is nothing. My non-positions may mean I will miss the first 15% of the rebound, but I will be ready to jump in with cash when it does turn.
TER: Once oil prices start to turn, what sectors will start to look attractive first?
KS: If we saw oil turning around to the positive, we'd immediately look to the producers. Really, you just want to own the best names.
"We will continue to have excess supply for the foreseeable future."
In the U.S., that might be Matador Resources Co. (MTDR:NYSE). In Canada, it's Raging River Exploration Inc. (RRX:TSX.V) and Whitecap Resources Inc. (WCP:TSX.V) on the junior/intermediate side. These companies work at very low oil prices—surprisingly low prices. Canadian companies are way better off because the Canadian dollar has cushioned the blow for producers. Sadly, it's hurt consumers because the price of gasoline is $0.25/liter higher than what it should be if the Canadian dollar were still at $0.90. But it has saved the producers' bacon.
TER: Other than the exchange rate, what makes Raging River and Whitecap the companies to watch?
KS: Raging River is on everybody's list. CEO Neil Roszell and his team have great cost discipline. The company's Viking assets in Saskatchewan are relatively shallow. The company has been able to reduce oil well capital expenditures from $900,000 ($900K) per well to $700K per well. They pay out in 18–20 months at these low prices.
At Whitecap, Grant Fagerheim and his team have done a great job putting together a whole suite of assets that a year ago all had less than one-year payouts. That's really unusual. Most companies that have more than one play have one lead with a payout of a year, whereas Fagerheim has put all of his plays together like that. That's amazing. When things turn around, those are the stocks you want to go buy.
TER: It looks like Whitecap is still paying a dividend?
KS: Yes, it is still paying a dividend, and its sustainability ratio is pretty close to 100%. That means the money the company is putting into the ground drilling, and how much it's paying out in dividends, is more or less its cash flow. Obviously, you want your cash flow be greater than your expenses. Oil only has to go up marginally for that to happen. That's pretty unique in the business today.
TER: You have written about the prospects for Canadian liquefied natural gas (LNG). What companies should investors be watching in that sector?
KS: LNG prices around the world are quite low right now. Costs are lower, and there's lots of supply coming onstream, but big companies like Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and Exxon Mobil Corp. (XOM:NYSE) have invested heavily in LNG projects in British Columbia because they know when oil prices come back, another huge disconnect from gas will occur.
Right now, oil and gas are actually quite close in price per British thermal unit (Btu). But when oil was at $100/bbl, gas was $3/bbl, and that spurred a lot of demand for gas. Companies like Shell look at 20-, 30-, even 40-year cycles. And they like what they see.
"Higher interest rates would put some discipline into this oil bucket."
The math on oil is quite simple. There are only 4 million barrels a day (4 MMbbl/d) of excess capacity today, and I would suggest it's even less than that. We lose 4 MMbbl/d in natural decline per year, and no one is drilling for new oil at these prices. So it won't take long for the market to come back into equilibrium. When oil is once again much more expensive than gas, you'll see demand for gas rocket right back up. I think that's what these big guys are seeing, and why they are still moving forward in a big way on gas projects. They understand that you have to work the cycle two or three times over the life of your asset, and you're going to make most of your money at the top and not very much at the bottom. They see today as the bottom that sets them up for success at the top of the next cycle.
I was a real bear on natural gas earlier this year, and both natural gas stocks and natural gas prices hung in way better than I expected. We're not at the $7 per billion cubic feet we were at last year or two years ago. But structural demand has kept pace. The North American gas market is now incredibly leveraged to one play, the Marcellus.
In Canada, the Montney is increasing production. If it had more pipeline capacity, it could produce quite a bit more, but it still pales compared to the Marcellus. A lot of people are watching Marcellus production very closely because natural gas is a binary trade in North America. Until the production of the Marcellus and the Utica (underneath the Marcellus) peaks, gas prices are going to stay under pressure.
But as soon as the Street has any confidence that Marcellus/Utica production has peaked, get long gas, because structural demand has increased so much. LNG exports could occur as early as October out of Cheniere Energy Inc. (LNG:NYSE.MKT) in Louisiana. Mexican exports of gas have been much higher than I expected to see this year. I'm not rushing out to buy any gas stocks, but that market has my attention more now than it ever has in the past.
"If we saw oil turning around to the positive, we'd immediately look to the producers."
LNG in Canada is a bit of a binary trade right now with the Canadian election coming up Oct. 19. If a left-wing New Democratic Party (NDP) government gets in, I think LNG is going to be dead for six months to a year while LNG policies are hashed out. But if the right-wing Conservatives get back in, then I think Shell, in particular, but also Petronas, will probably move forward. The companies that will benefit first are the construction companies, like Petrowest Corp. (PRW:TSX) and Entrec Corp. (ENT:TSX.V), along with bigger companies like Aecon Group Inc. (ARE:TSX) and Bird Construction Inc. (BDT:TSX), which build the infrastructure for the pipelines. On the LNG side, that's where I think investors should be looking, and making sure their shopping lists are ready.
TER: If the majors are planning how they are going to replace reserves when the market turns, does that mean that we are in store for more merger and acquisition (M&A) activity?
KS: Oh, yes. You'll definitely see it, but I think it will get done in a much more disciplined context. You will see quite a rush to bring on more production, but I think the lenders are going to be more disciplined on debt:cash flow ratios.
"Investors really want to be cautious over the next couple of months until we see what's going to happen with the Canadian election."
The prices for M&A actually haven't come down very much, despite quite a bit lower commodity prices, which really surprises me. We haven't had a big deal get done in the last month, when oil prices really took the tank. There's so much private equity money sitting on the sidelines waiting to pounce into this market that it is creating way more optimism on the seller's side than is warranted by the prices we're seeing today.
I really thought we were going to see an unbelievable amount of M&A in Q4/15. Now, I'm just not so convinced, because there is still a lot of hope out there. The financial community is known to be pretty lenient in foregoing its credit terms. I think, sadly, we're going to see a lot of these zombie companies hang on for longer than they deserve to.
Another challenge that will face the industry when the oil price comes back is the gap in energy services that has developed. We have lost a lot of technical talent on the services side. I don't know how quickly that's going to come back. A lot of rigs have been sold, and they're not going to be easy to get back. And talent is not going to be easy to get back. So if this does turn around in a hurry, that's going to exacerbate costs. The service side should benefit quite a bit.
TER: Are there service companies that you follow?
KS: There are a lot. As the service industry turns, first we will see an increase in volume, and then an increase in margin. Companies like Canyon Services Group Inc. (FRC:TSX) on the fracking side could benefit.
Fracking sand companies like Emerge Energy Services LP (EMES:NYSE) and U.S. Silica Holdings Inc. (SLCA:NYSE) will have lots of leverage. They all have small share floats. The amount of sand being used actually hasn't dropped that much. So if there was a rebound and there was an increased demand for sand, those stocks would do quite well. They're highly leveraged to an increase in activity.
Service companies like Gibson Energy Inc. (GEI:TSX) had their stocks crushed just as much. They would probably have the first big bounce. Canadian Energy Services and Technology Corp. (CEU:TSX), Secure Energy Services (SES:TSX) and Gibson would have pretty massive turnarounds. Then the smaller guys would follow suit a couple months later, if the sector was still moving up.
TER: What words of wisdom do you have for energy investors trying to do the right thing for their portfolios during a difficult time?
KS: The more cash you have as we're going into the very choppy months of September/October, the better. On the Canadian side, you really want to be cautious over the next couple of months until you see what's going to happen with that election.
TER: Thank you Keith.
Keith Schaefer is editor and publisher of the Oil & Gas Investments Bulletin, which finds, researches and profiles growing oil and gas companies that Schaefer buys himself, so Bulletin subscribers know he has his own money on the line. He identifies oil and gas companies that have high or potentially high growth rates and that are covered by several research analysts. He has a degree in journalism and has worked for several Canadian dailies but has spent over 15 years assisting public resource companies in raising exploration and expansion capital.
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