In May 2016, we attended a panel event discussing investment opportunities in the financially distressed oil and gas sector. The panel included a “who’s who” of oil and gas experts located in Texas. Two industry participants, two consultants, one analyst and one economist discussed the economic outlook for energy prices and then corporate strategy and investment opportunities given the economic outlook. This post, the second and last summarizing this panel discussion, will report opinions given on corporate strategy and investment opportunities. (To read more about the economic outlook please read here.)
After discussing the price outlook, the panelists shifted the conversation to practical decision making based on our limited ability to forecast price changes. First, they looked at corporate strategy. Merger and acquisition activity has slowed. Once oil prices started to decline in mid-to-late 2014, the M&A market fell quiet for more than 12 months. This “silent period” is a normal reaction to high volatility periods. For corporations trying to make decisions for the long term, volatility creates an uncertain future, and thus an unfriendly environment for investment. However, the panelists believe the “silent period” is now reaching a breaking point as the amount of debt carried by some companies is beginning to force action. One panelist commented that while there are “no willing sellers in the market,” some transactions have occurred when a “forced seller” tries to avoid or prolong filing for bankruptcy protection.
Those bankruptcies are happening more and more frequently, leading one participant to describe four types of energy companies in the market today:
- The “I need to restructure yesterday” company;
- The “In denial about restructuring” company;
- The “Racing to restructure” company (to be healthier when oil prices recover); and
- The “Low leverage / healthy” company (looking for opportunities);
By categorizing each active company in the oil and gas market into one of these four buckets, it is easier to interpret some companies’ actions, and therefore to interpret the direction of the market. This in turn enables wiser investment strategies.
Two areas of opportunity discussed were reserves and oil field services. A panelist who actively invests in “low risk, existing producing properties with PUD (proved undeveloped wells) rights” described the potential value of investing in reserves. In recent transactions, this particular panelist was able to pay a purchase price based only on the value of the given property’s PDPs (proved developed producing reserves). The only properties for which he may make an exception and allocate “a little” value for the non-producing areas are those located in the Permian Basin. The time horizon for this investment is definitely long term as the strategy depends on the price of oil recovering so that the PUD opportunities—which the investor pays nothing for in this current market—become valuable again. Thus, this strategy works well for experienced investors with enough cash to pull it off, such as investment funds or other E&P companies.
The second investing opportunity is more easily accessible to the average retail investor than purchasing reserves. This simpler opportunity focuses on investing in “higher quality oil field service companies that live in the operating expenses of exploration and production companies.” There are a couple positives to this strategy. Since existing wells must be maintained, this strategy enables one to invest in a high quality company that receives regular business from E&P companies, while also taking advantage of the fact that most companies operating in the oil and gas sector are trading at discounted prices. Furthermore, if prices recover, more wells will be drilled and completed, and these too will need to be maintained. Thus, high quality oilfield service companies may offer low risk returns in the current environment while also offering considerable upside if oil prices increase. A market data point to monitor for this investment strategy is the drilled but uncompleted well count and the well completion count data. As discussed in the previous post, this information is more directly tied to future production than the commonly referred to rig count data, and an increase in completions will mean an increase in business for oil field services companies.
Overall, this panel was a helpful reminder to stay focused on the basics during times of turmoil. Basic supply and demand factors world-wide are still driving the price of oil and gas. The only change has been the behavior of certain suppliers (OPEC) and doubts about future demand (country specific). Because of the way those changes have affected oil prices, overleveraged E&P companies will be forced to restructure their debt or be forced out of the market. After an 18 month “silent period,” more action is either expected in the near term as these debts become due. Lastly, having available, investable cash is critical in order to take advantage of certain investing opportunities in the market today. Certain strategies favor professional and institutional investors, while others can be enjoyed by retail investors. Overall, it is a very volatile time in oil and gas. The perspectives of these six experts in their respective fields provide guidance for strategy and investing in the near and long term. If you want to move forward either as a company interested in M&A activity or as an investor, utilizing an experienced oil and gas reserve appraiser can help to further lift the fog on valuation issues in this current, hazy environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.