Introduction to my investment philosophy and methodology.
Petroleum Producing Industry Overview.
Top companies in this industry by the numbers.
Conclusions.
Introduction: investment philosophy and methodology
I want to begin by explaining a little about my investment
philosophy: My focus is to add income when it is cheap enough. In
other words, I like to determine the ideal yield I would accept
from a stock as my target for entering a new position. I rely on my
patience that took some time and age to develop. A good example
that illustrates these principles, if you are interested, is a
recent articlethat I wrote about
XOM.
If you are not familiar with how I analyze companies and
industries please consider my age-old favorite, "
The Dividend Investors' Guide to
Successful Investing," where I provide more details about my
process for selecting companies for my master list and details
about why I use the metrics that I do. I have made one primary
adjustment from that earlier set of rules regarding the debt to
total capital ratio. While I remain very cautious regarding free
cash flow and companies' ability to service and repay debt if the
economy experiences another financial crisis, which I still believe
is very possible, I place an emphasis on debt levels relative to a
company's industry peers. But I have adjusted my calculation to be
more in line with traditional convention and now use the total of
debt plus equity to represent total capital. It is easier to
understand and there is really very little difference from my
earlier method, so the variance is of little consequence.
Petroleum Producing Industry Overview
I know what you must be thinking. This looks like an attempt to
put lipstick on a pig! Bear with me and you will realize that I am
doing nothing of the sort. For the last year this industry has been
wallowing in the mud, stinking up the place and doing a very good
impression of a pig, but without lipstick. But that is the past. We
need to look at the future. Uh-oh. Well, the near future does not
look very good either. In other words, even the leaders in this
industry will require patience to find a good entry point. But that
will come and then the potential of the best companies will be
worth a good hard look. So, today we are doing a little homework to
prepare us for establishing a good rising income stream.
So, why am I writing about this industry now? The simple answer
is that I hope to give my readers a little insight into what
patience can do for portfolio returns. We may not be able to pick
the exact bottom, but we certainly can avoid the pain of entering
before the worst is behind us. I expect more downside here and I
want my readers to take the proper precautions when considering a
beaten down company. It could get beaten down even more and give us
a REAL bargain! Those companies that are able to adapt to lower
prices will consolidate and grow.
As many readers who are familiar with my work know, I once
expected the price of oil to remain elevated. That was before the
widespread adoption of hydraulic fracturing in the U.S. oil and gas
industries. Now that there seems to be an abundance of oil and
natural gas it seems more likely that prices will remain tamer with
a lower ceiling that was the case prior to 2011. How technology
changes our lives and our investment thesis. If you would like to
understand more about my view on oil and natural gas prices in the
short, intermediate and long terms, please refer to my three
article series,
Energy Sector Outlook.
At the same time, many older producing fields are still
experiencing declines in production. Technology has brought some
new life into gathering more oil from wells and fields that were
previously considered uneconomical. But the application of that
technology also depends heavily on the price of oil remaining north
of $60 or $80 per barrel, depending on where the reserves are
located. Here is what I said in 2012 in an earlier article:
"So, if demand falls enough to cause the price of oil to drop
below the magic number for too long, wells will be capped,
production will be reduced and exploration drilling will come to a
halt in high-cost areas. The result will be an equilibrium between
demand and supply that props the price of a barrel of oil back up
high enough to reopen wells and restart projects that had been shut
down. But the equilibrium won't happen overnight. We would fist
need to suffer through much higher prices for a period deemed long
enough to make capital investment seem less risky. Our comfort is
not the subject of what determines optimal pricing; profit is the
goal. It always has been and always will be."
Admittedly, I had it backwards back then. First we will have to
endure lower prices until an equilibrium between demand and supply
is reached. Then prices may edge higher if demand can outpace
supply. As I point out in the Energy Sector Outlook articles, the
abundance of supply and known reserves yet to be developed should
hold prices below the $100 mark for the next five years or more, or
at least during most of that time. There is always the potential
for wild swings due to geopolitical and major weather events, but
those are generally temporary in nature. When the price of oil get
much above $70 I expect supply to begin to flow as wells that have
been shut in or drilled but not yet completed will be brought into
production if that price level can be locked in using hedging
strategies. I also think that many companies in the industry have
learned the lesson about balancing greed and hedging this time. Let
us hope!
Top Companies by the numbers
Even with that introduction, I need to add a few more words of
caution. This list does not constitute a recommendation to buy any
of these companies at current prices. I believe we will get a
better opportunity to buy these assets after the waves of
bankruptcies get up a head of steam (again covered in depth in the
article linked above). Also, please understand that I generally
only update industry analysis once a year so all data (except
price, dividend and yield which are current) are taken from
year-end, audited financial reports.
Now, having set this up to be based upon the numbers, I really
have to explain that this industry (or any other industry when it
is as distressed to this extent) will look horrible by the numbers.
What we are trying to do is find the best "future" picks that we
will focus on when the time is appropriate, add them to our list,
and wait for a better entry point.
With that in mind, the factors that matter the most to me right
now are those that will enable a company to survive the worst
conditions (and I expect things to get even worse by year-end),
then play a role in consolidating the best assets, and rise like a
phoenix when the worst is over. To that end, I will be placing more
emphasis on cash flow management, balance sheet strength, net
margins (the least worst) and asset quality. The last one is
subjective and ties into net margins because the companies that
have the lowest cost of production will generally have better net
margins and that usually results from higher quality assets.
Production costs are costs to operate and maintain the Company's
wells, related equipment, and supporting facilities, including the
cost of labor, well service and repair, location maintenance, power
and fuel, gathering, processing, transportation, other taxes, and
production-related general and administrative costs.
The companies are not exactly fully transparent regarding the
respective lifting costs (the cost to extract a resource out of the
ground once drilling and well completion have been done). I only
found this figure broken out in two instances. Thus, to make things
comparable, I calculated production cost using the above definition
which I found in the latest annual report of Anadarko Petroleum
(NYSE:
APC). By calculating it the same for each
company we have a better gauge of how each one compares to its
peers.
One last adjustment to my normal assessment; I used the
four-year compounded average growth rate in EPS instead of the
five-year. The reason I did so is that 2009 would have been year
one and the industry was in shambles then, too, due to the
financial crisis and because having a negative number in year one
really skews the rate.
Apache Corporation(NYSE:
APA) has exploration and production (E&P)
operations in the U.S., Canada, Australia, Argentina, Egypt and the
North Sea. The company produces natural gas (32% of 2011 oil
equivalent production), oil and natural gas liquids [NGLs]. APA is
well-positioned in terms of reserves and capacity to increase
production to meet future demand. In 2014 APA produced 218.3
million barrels of oil and NGLs; 651,109 million cubic feet (Mmcf)
of natural gas. Revenue broke down as 49 percent from oil and 51
percent from natural gas. It reported reserved at the end of 2014
at: 1,147 million barrels of oil and NGLs; 8.4 Tcf of natural
gas.
APA has a good habit of acquiring reserve assets from other
struggling companies in the industry when asset prices are
reasonable. However, it has over paid in recent years just like
everyone else in the industry. Over the long term, though, I like
this company's buy low, develop and sell higher strategy.
Management appears to be cutting costs in an attempt to sustain
profitability in a low oil price environment. It may have a
difficult time while the price of oil is much below $40, but should
prosper with prices above $50. Apache's cost of production is
$17.21 per barrel of oil equivalent [BOE]. Among the pure E&P
companies I reviewed this is the lowest cost of production.
Let's look at the metrics.
Metric
APA
Industry Average
Grade
Dividend Yield
2.1%
1.1%
Pass
Debt-to-Capital Ratio
32.3%
36.2%
Pass
Payout Ratio
NMF
24.5%
Fail
5-Yr Ave. Annual Div. Incr.
10.8%
10.2%
Pass
Free Cash Flow
-$10.81
N/A
Fail
Net Profit Margin
NMF
14.9%
Fail
4-Yr Ave. Annual Growth - EPS
NMF
1.7%
Fail
Return on Total Capital
NMF
6.5%
Fail
5-Yr Ave. Annual Growth - Rev.
7.5%
7.4%
Pass
S&P Credit Rating
BBB+
N/A
Pass
Since I base the numbers and ratios on annual data (because the
annual statements are audited whereas quarterly are not), we need
to take into account the asset write downs and how these amounts
may affect future earnings potential. APA had over $5 billion in
asset write downs and impairments in 2014, which caused EPS to be
negative. The number would be only slightly positive and down from
2013 if we remove these non-cash expenses. Apache looks terrible
from a purely pass/fail aspect; five passes and five fails. Where
you see NMF it means not meaningful and designates that the number
was a ratio above 100 percent. Three of those ratios are so large
because of the non-cash expenses. The average annual growth in EPS
is also attributable primarily to the non-cash expenses but would
still be negative.
This company has been a perennial leader in its industry and
will probably recover to earn back that mantle again in the future.
It is one we need to watch carefully to see how well it adapts to
the lower cost environment before considering an investment.
I am a long-term owner of ConocoPhillips (NYSE:
COP). COP has E&P operations in nearly 30
countries around the globe. The company had 8.9 billion barrels of
oil equivalent in proven reserves at the end of 2014. Total
production in 2014 averaged over 1.5 million BOE per day. While COP
has produced well over 1 billion BOE since 2011 its reserves have
increased meaning it is more than replacing reserves. That bodes
well for the long term and since COP will be well positioned to
benefit from the coming consolidation, I expect reserves to rise
faster in the next two years. Production costs in 2014 were
$20.87/BOE.
Let's see how COP fared against the metrics.
Metric
COP
Industry Average
Grade
Dividend Yield
5.9%
1.1%
Pass
Debt-to-Capital Ratio
32.5%
36.2%
Pass
Payout Ratio
57.0%
24.5%
Fail
5-Yr Ave. Annual Div. Incr.
6.6%
10.2%
Fail
Free Cash Flow
-$2.09
N/A
Neutral
Net Profit Margin
11.8%
14.9%
Neutral
4-Yr Ave. Annual Growth - EPS
-4.3%
1.7%
Fail
Return on Total Capital
8.8%
6.5%
Pass
5-Yr Ave. Annual Growth - Rev.
-15.7%
7.4%
Fail
S&P Credit Rating
A
N/A
Pass
Only four pass, two neutral and four fail ratings. The same old
story of write downs and impairments will run throughout the
industry. COP is no different and there will be more through at
least year-end. COP is cutting capital spending, like most others
in the industry, to enable management to uphold its pledge to
continue increasing its dividend. I like the commitment to return
capital to shareholders in the form of dividends. But the share
price has more downside to come before things get better, in my
opinion.
The company is canceling deep water drilling efforts in the Gulf
of Mexico for the time being and will pay a hefty cancellation
penalty on a drilling rig contract, probably in the third quarter.
The current year is going to be difficult for COP. But the company
and its management are worth considering after it has worked
through these difficult adjustments. It will benefit from being
able to acquire low cost assets and reserves as the industry
consolidates.
The next company I considered is Marathon Oil (NYSE:
MRO). Like COP, MRO split its operations and
spun off the downstream assets into a stand-alone company. The
timing seemed right at the time with oil prices elevated; now, not
so much.
Reserves were about 2.2 billion BOE (as of December 31, 2014)
and daily production in 2014 amounted to 285,000 barrels of oil and
808 Mcf of natural gas. Aggressive cost cutting initiatives are the
focus of management, including capital spending. But more will need
to be done to return to profitability as long as the price of oil
remains so low. Production costs in 2014 were $22.63/BOE.
Metric
MRO
Industry Average
Grade
Dividend Yield
4.7%
1.1%
Pass
Debt-to-Capital Ratio
23.3%
36.2%
Pass
Payout Ratio
56.0%
24.5%
Fail
5-Yr Ave. Annual Div. Incr.
7.3%
10.2%
Fail
Free Cash Flow
-$2.01
N/A
Neutral
Net Profit Margin
8.9%
14.9%
Fail
3-Yr Ave. Annual Growth - EPS
-15.9%
1.7%
Fail
Return on Total Capital
4.2%
6.5%
Fail
5-Yr Ave. Annual Growth -Rev.
-9.5
7.4%
Fail
S&P Credit Rating
BBB
N/A
Pass
Marathon achieved only three pass ratings along with one neutral
and six fails. I like the yield but either of the preceding
companies is likely to outperform MRO over the long term. But we
need to watch how the various management teams react to the lower
pricing environment before we pass final judgment.
Anadarko Petroleum is another well run behemoth in the oil
patch. It is suffering the same fate as its peers, though. APC has
another problem in the short term: the Supreme Court ruled against
APC in the 2010 Macondo oil spill incident in the Gulf of Mexico.
That could leave the company liable for up to $1 billion in civil
suits. The good news for prospective investors is that it will
probably get worse before it gets better. But the company has some
excellent reserves around the world it is determined to hold onto
for long-term development.
Proved reserves at the end of 2014 were 2.86 billion BOE, but
APC is one the best companies at increasing reserves having a
five-year average reserve replacement ratio of over 600 percent.
Daily production in 2014: 126.3 million barrels of oil and NGLs;
1.356 Bcf of natural gas. Production costs in 2014 were
$21.08/BOE.
Metric
APC
Industry Average
Grade
Dividend Yield
1.4%
1.1%
Pass
Debt-to-Capital Ratio
45.7%
36.2%
Neutral
Payout Ratio
47.0%
24.5%
Fail
5-Yr Ave. Annual Div. Incr.
24.6%
10.2%
Pass
Free Cash Flow
-$9.38
N/A
Fail
Net Profit Margin
5.9%
14.9%
Fail
4-Yr Ave. Annual Growth - EPS
8.8%
1.7%
Pass
Return on Total Capital
3.9%
6.5%
Fail
5-Yr Ave. Annual Growth - Rev.
14.8%
7.4%
Pass
S&P Credit Rating
BBB
N/A
Pass
Five pass ratings is the best so far; with one neutral and four
fails. This is still not a stellar report card by any stretch of
the imagination. The company has much yet to do but, like the
others mentioned above, will survive due to its size and its
ability to adapt. Adapting to the environment is crucial for
survival in this industry. APC has some great assets and will sell
some of the less desirable assets to preserve its future
developmental potential. We need to keep an eye on this one to see
if it can make the adjustments necessary to weather this storm.
The last company I want to keep a close eye on is Canadian
Natural Resources (NYSE:
CNQ). The share price has already dropped over
50 percent from its 2014 high, but there should still be some more
downside as the industry continues to get beaten down by falling
oil prices. Proven reserves work out to be 4.5 billion barrels of
liquids; 6 Tcf of natural gas. Daily 2014 production: 531 million
barrels of liquids and 1.55 Bcf of natural gas. The average
production costs are a little higher for CNQ at $29.47/BOE, but
still not outlandish. Controlling costs and reining in capital
expenses will be the test that management needs to master, as is
the case across the board in this industry. But, thus far, CNQ has
performed better in many ways than its peers.
Metric
CNQ
Industry Average
Grade
Dividend Yield
3.9%
1.1%
Pass
Debt-to-Capital Ratio
31.5%
36.2%
Pass
Payout Ratio
25%
24.5%
Pass
5-Yr Ave. Annual Div. Incr.
25.1%
10.2%
Pass
Free Cash Flow
-$1.39
N/A
Neutral
Net Profit Margin
17.9%
14.9%
Pass
4-Yr Ave. Annual Growth - EPS
10.1%
1.7%
Pass
Return on Total Capital
9.7%
6.5%
Pass
5-Yr Ave. Annual Growth - Rev.
13.8%
7.4%
Pass
S&P Credit Rating
BBB+
N/A
Pass
Holy cow! Nine pass ratings and one neutral. By far the best of
the group and a very big surprise to me. But that is a measurement
of the past performance. The dividend increases will likely slow
significantly for the next two years, but should then be above the
industry average again. The yield is strong and debt is under
control. Cash flow is not negative by much and can be improved with
reductions in capital investments and operational cost cutting. The
company will struggle to make a profit in 2015 but could be well
positioned for a rebound sometime in 2016, depending on what
happens to energy prices between now and then. I will hold off
investing in this one until we find a bottom in the price of oil
and the bankruptcy announcements begin to taper off. Even then I
will want to take another look to confirm whether management has
been up to the task.
I plan to write focus articles to provide more in depth analysis
on each of these companies as oil prices find a bottom the
supply/demand imbalance shows stronger signs of correcting.
As for those other companies that did not make the list, I will
remind readers that I do not include a company unless it pays a
dividend or if it cuts its dividend, and I also do not include
companies that have unsustainable negative free cash flow. These
two exclusionary conditions were present in nearly every other
company in the industry that I follow. I also do not follow
companies that are not listed on U.S. exchanges with consistent
trading volume liquidity.
As companies in this industry adapt to the lower pricing
environment I will try to review each and add it to the list. At
the present time, the companies listed above are the ones I expect
to survive and potentially provide investors above average income
and growth potential.
This industry is extremely volatile as fortunes of success are
directly dependent upon the prices of oil (and to a varying extent,
natural gas). When the price of oil goes down below the cost of
production for many operating wells and fields, as is the current
case, companies here lose money. Even those companies that have
production costs below the price of oil can lose money due to the
corporate overhead, interest expenses and capital expenditures that
do not result in productive assets and must be expensed (dry
holes).
But the flip side is tantalizing to those who possess a
long-term view. When oil prices rise enough to make virtually all
wells and fields profitable again, the price of stocks in this
industry have the potential to soar, providing the selective,
patient investor opportunities of massive gains. The key here, as
in all successful investing, is to avoid the big losses.
Waiting for the right entry point on the right stock is the best
advice I can provide, especially when considering investing in this
industry. I like to decide first upon a yield that I am willing to
accept from each industry, then select from the list above. his way
I believe that I have bought a quality company at a bargain that
provides a yield that suits my portfolio and adds enough income to
allow me to wait patiently for the stock to rebound so I can reap
the terrific potential appreciation that lies ahead.
This analysis has proven to be difficult in that I cannot, in
good conscience, recommend a single company for purchase at current
levels. It may also prove to be timely in that many pundits seem to
believe that the lows are in place and that great values abound. I
disagree! The price of oil may, in fact, experience a rebound once
again before plummeting further. Any rebound will undoubtedly be
touted as proof that the pundits are right. Memories will be
short-lived when oil prices finally make new lows.
For those who are concerned that they could miss out on what
appears (mirages are always beautiful!) to be a great entry for
value investors, I would only add a portion (one quarter or a
third) of the full position desired at these levels. If I am right,
you can lower your cost basis by adding more when the real bottom
is in. If I am wrong, you will not have missed completely the great
bottom in oil prices. However, if you really are considering buying
shares in this industry now, please take a few moments and read my
article linked earlier, if you haven't already, entitled, "
Energy Sector Outlook," as it
contains a very valuable history lesson on energy prices that all
energy investor really need to understand!
As always, I welcome comments and will try to address any
concerns or questions either in the comments section or in a future
article as soon as I can. The great thing about Seeking Alpha is
that we can agree to disagree and, through respectful discussion,
learn from each other's experience and knowledge.
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