North American oil and gas: Caveat emptor

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The oil and gas industry was shocked as oil prices fell by more than half, from $104.48 per barrel in July 2014 to $51.53 in March 2015. While prices have recovered since, they remain well below the $100 per barrel level that producers and consumers are accustomed to. Valuations have also fallen, in some cases rather steeply. This sudden shift has escalated investors’ interest in the sector, especially in North America, where private-equity firms and others have accumulated a war chest of more than $80 billion specifically intended for upstream assets. Investors are moving quickly to evaluate acquisitions across the value chain, with exploration and production (E&P) and oil-field services garnering the most interest.

The logic behind this surge seems robust. While most investors are rightly cautious about a recovery of prices to former levels, they believe that the market rout is cyclical rather than structural, and the low prices seen in early 2015 are unlikely to last. Oil demand is expected to grow for the next decade in most scenarios. In a scenario where oil prices return to equilibrium between $65 and $85 a barrel, both onshore and offshore unconventional assets (including deepwater) will contribute more to the global oil-supply “stack” (Exhibit 1). Investors that believe in this scenario find today’s market to be a buying opportunity for good-quality assets.

Spare capacity will be reduced

This argument has certainly been behind some prominent deals recently. In January 2015, Blackstone’s $70 billion credit arm, GSO Capital Partners, committed up to $500 million to help cash-strapped LINN Energy develop its production assets. Two months later, Kohlberg Kravis Roberts & Co. bought $135 million of discounted loans that were used to finance the 2014 buyout of Scottish oil-field-services firm Proserv, a provider of subsea equipment and services.

These deals notwithstanding, the wave of M&A and consolidation that some industry watchers predicted has not yet happened. In the first quarter of 2015, just 49 deals worth $10 million or more were announced. That’s down from 2014, when at least 104 deals (and as many as 149) got done every quarter. The total value of M&A in the first quarter of 2015 is also down from 2014, at $9 billion relative to quarterly totals of $50 billion to $88 billion in 2014. We see three primary explanations for this:

  • North American operators have quickly adjusted to the new reality by rapidly cutting their activity (the rig count has halved, to fewer than 900 rigs), shifting development to the most prospective and predictable parts of their acreage (driving up initial production rates by more than 25 percent in some cases), and driving down development costs (by between 30 and 40 percent at many big unconventional operators).
  • Firms are financially stronger than expected. Many operators enjoyed cheap and covenant-light credit before the crash and had large revolvers of debt that they could draw on. While these lines begin to mature next year, they are sustaining operators through the down cycle. Also, production at many operators is hedged.

    In a sample of 25 US E&P companies we studied, around 54 percent of oil production in 2014 was hedged through a combination of fixed-price swaps and three-way collars. Hedged production drops to around 30 percent in 2015 and around 15 percent in 2016.

  • Several pure-play E&P companies seem to be valued by the market at substantially higher levels than can be justified by current prices. For example, the economic value of one operator in the Permian Basin is down by just 17 percent since 2014, in spite of a much larger drop in oil prices. To believe this valuation, the market would also have to believe that oil will return to $80 a barrel, that the company can reduce capital expenditures by around 30 to 40 percent on future wells (even though it has increased 15 percent annually for the past several years), and that the company’s acreage in a new play can be “down spaced” to close to 40 acres per well, similar to what is only now being achieved in the most advanced sections of the Eagle Ford and Bakken Formations.

Does this mean that the E&P subsector is an unattractive one for investment? Hardly. We believe that investment opportunities can be found by patient investors with a fundamental approach. We recently examined nearly 1,000 E&P companies operating in North America and benchmarked their operations “outside-in” to understand how they performed on essential sources of value such as asset quality; drilling performance; selling, general, and administrative performance; and other metrics. We adjusted for geological differences and weighted the attributes for their relative impact on value creation. The result is an intrinsic-valuation index, which we then compared with the capital markets’ perspective. A snapshot of the resulting analysis (large light-tight-oil producers) is shown in Exhibit 2. Across all the 1,000 or so E&P firms we studied, less than 5 percent can truly be called undervalued.

Few unconventional producers are currently distressed.

That picture may change over time; if prices stay low, more producers will become distressed. Investors can also take heart that distress is only one of several possible investment themes. Opportunities for recompletions of older wells, high-quality management teams, and other themes offer ways to drive value.

Finally, a word on North American oil-field-services companies. Many investors struggle with the subsector, perceiving it to have low entry barriers, high cyclical exposure, and a mixed history of “real” value creation. While these concerns are valid, we believe that there are certain niches that offer a promising upside at current valuation levels. A rapid drop in demand has driven some small mom-and-pop firms out of business, granting more pricing power and other benefits to the survivors. In some niches, companies are more exposed to operating expenses, rather than capital expenditures, and their earnings have not suffered the way that companies in other segments have. The market has not completely recognized this difference, which might represent a buying opportunity.

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