Over the past four months, we have seen a dramatic sell off in the Energy and Basic Materials sector. Most of this is due to two factors: the price of crude oil has dropped and the dollar has strengthened recently. This has caused fear in the market, assuming that some oil and energy companies will be driven into unprofitable territory. In this post, we will take a top level analysis over the sector, which will help point us in the right direction. It is my opinion that the correction in the energy and basic materials sector is an overreaction to recent macro events. This analysis will help determine the opportunities within the carnage.

Since around July the dollar started to climb against other major currencies. When compared to other currencies, the dollar has appreciated 16.8% against the yen and 8.1% against the euro. Due to the dollar strengthening, commodities have fallen as a result. Most notably, crude oil has fallen nearly 30% since its June highs of around $107 a barrel, to around $74 a barrel as of this writing.

US Dollar Index 12 Months

WTI Crude Oil Spot Price 12 Months

These two events related or not, have caused chaos within the oil, gas, and basic materials sector. To illustrate this, the Guggenheim S&P 500 Equal Weight Energy ETF (RYE) has dropped 15.29% over the past four months. As this is the index, it doesn’t show some companies that are down 30%+ over the last couple of months. This could very well be an overreaction and be a buying opportunity. Below is an analysis of over 60 different companies, split between six different groups: Major Integrated, Exploration & Production, Drillers, Refiners & Marketing, Servicers, and Chemical companies. Due to length and time constraints, I have decided to break this research up into two separate articles. This article will focus on the Majors, E&P, and Drillers, with the next article focusing on Refiners, Servicers, and Chemical companies.

How Did We Get Here & Why is the Drop in Oil Important?

Typically, OPEC has had great influence over the price of oil, which prevents large crashes in the price per barrel. OPEC typically obtains favorable pricing by cutting or expanding production to control the supply and therefore the price of oil. However, since around 2000 the US has discovered a way to extract shale oil through hydraulic fracturing techniques that was not known prior.

This has created an oil and gas boom inside the U.S. that is unlike anything before. Due to laws preventing the US to export crude oil, supplies have started to build, which has put pressure on the price of oil, and also taking power and influence away from OPEC. Other areas that have caused excess supply is the buildup of Libya and Iraq as there is no longer conflict in those areas and are getting back up to speed. A great article about the situation can be found over at Vox.com which can be found HERE. One of the most important graphics from that article is the budgetary breakeven points of the OPEC nations, most notably Saudi Arabia:

Saudi Arabia is the world’s largest producer and exporter of oil and has one quarter of the world’s known oil reserves. According to OPEC, “the oil and gas sector accounts for about 50 percent” of Saudi Arabia’s GDP. Due to this, they are the most influential voice inside OPEC, and according to this research, their budgetary breakeven price is around $90 per barrel of oil.

OPEC meets on November 27th, 2014 in Vienna, Austria, to discuss the recent events. It will be interesting to see what the group decides. There are some that believe OPEC will cut production to take supply off the market. Meanwhile, with the U.S. becoming energy independent, others think OPEC might enact in a price war, pushing U.S. shale operators into unprofitable territory. Either way, oil prices below $80 per barrel are not sustainable for long to the majority of producers out there, whether it’s OPEC or independent companies.

Oil Prices Moving Forward

Now that we know the current situation, let’s look briefly at the direction we are going with the price of oil. While it is very difficult to forecast the price of oil, we can look at supply and demand, particularly within the U.S. According to the U.S. Energy Information Administration (EIA), global oil supply has outpaced demand by a substantial amount, resulting in a global stockpile of 400 thousand barrels per day in Q4 of 2014 and an additional build of another 400 thousand barrels per day in 2015.

The U.S. is one of the prime reasons behind this. Since 2005, we have had an increase of 48.26% in total oil production and have seen consumption fall 8.85% over that same period, with supply rising due to the expansion of shale production and demand falling due to the recession in 2008. This chart below from the EIA illustrates this:

Due to this information, the EIA has projected that we will see WTI crude prices to “average $80/barrel in the fourth quarter of 2014 and $78/barrel in 2015.” You can read more about the EIA’s short term energy forecast HERE. As you can see, EIA’s forecast of the spread between supply and demand will tighten until 2015 or so, level off, then start to widen again.

Predicting oil prices is extremely difficult, as the entire world has to be taken into account. The good news is since this chart was published in 2012, U.S. consumption increased 2.5% in 2013 and Q3 2014 GDP was just revised upward to 3.9%. As the economy expands, so does our consumption of oil, therefore GDP growth is often times a good indicator as to where we may be heading. This is what has crushed practically all oil and basic material stock prices down over the past four months, which leads us to our sector analysis.

Oil and Gas Sector Analysis

As stated from above, it may take a while for oil prices to rise from current levels. Not to mention that it will probably be years before we see $100 a barrel again. Knowing this, if we want to invest in this sector, we have to realize that it might take some time for a turnaround to occur. That said, it is often good to build positions in counter cyclical fashion as we might be able to buy into companies at fair prices. It is true that profitability will likely be down across the sector, however just because the price of oil falls it doesn’t mean that these businesses will be hurt in equal fashion. Companies can hedge the price of oil (hopefully already have), cut costs, or increase production.

Since it is typically best to look at the quality of assets within oil and gas companies, we will take a snapshot of the sector’s Return on Equity (ROE) against its Price to Book (P/B) and Debt to Equity (D/E). The reasoning for this is that if an oil and gas company can create high profitability on its assets, then it deserves a higher valuation on said assets. Likewise, since higher leverage can create higher ROE, a lower D/E will also result in higher valuation on those assets. Also because profitability within the sector will probably be much lower, companies with more debt will have higher risks as it will become harder to service the debt. If oil prices continue lower, and we enter unprofitable territory, the firms with the most debt will likely have the most troubles first. Within each of the 6 sections below, we will include a brief overview of that market segment, and include a ROE relationship against P/B and D/E.

This will help us determine which companies might be undervalued against their peers. What we are looking for are companies in the lower right quadrant of these histograms. We want oil and gas companies with high ROE and low P/BV and D/E. All data has been gathered from Morningstar or Yahoo! Finance and was not obtained from actual SEC financial documents. Any suggestion of undervalued assets should be further researched by pulling actual financials from the SEC and doing your own due diligence. Without further ado, let’s get started with the Oil & Gas Majors. Warning, lots of histograms ahead.

Oil & Gas Major Integrated

The first section of companies we will look at are the oil and gas majors. These are the largest oil and gas companies out there, which mean they are the lowest risk, lowest reward of our analysis. As most if not all of these companies are global in scale, they are also susceptible to the strength in the dollar and geopolitical risks. What this means is if it is a U.S. based company, they are taking 8% less profit on international sales from just a couple of months ago. Compound this with the price of oil dropping, and we have a one-two punch to their profitability. Along with the currency and commodity risks, the geopolitical risks are there as well. Most notably when Venezuela nationalized oil operations in 2007 or how energy sanctions against Russia threaten projects in the arctic.

Regardless, most of these companies have been around for decades and have withstood the vast majority of what the markets have thrown at them. Let’s take a look a look at the majors:

The relationship between ROE and P/BV is extremely consistent within the majors as the higher the ROE, the higher the P/BV.

There really is not a standout company compared to its peers here. Out of the group, Exxon Mobile (XOM) continues to be best in breed, having the lowest debt levels and highest ROE, therefore priced as a premium to the group. Across the board, the lowest debt brings the higher valuations as Chevron (CVX) and Royal Dutch Shell (RDS) are priced at a premium to others with similar ROE. The only possible mispricing in this group is either CVX is slightly undervalued or TOT is slightly overvalued as both have similar P/B and ROE with TOT having higher debt levels. It is interesting that PBR is sitting at about half of book value. However, it appears a socialist president just won the election in Brazil and due to this, it is probably best to stay away from them. Next, we will move onto the Exploration & Production companies.

Exploration & Production

As mentioned previously, this is the area of the market that has been causing much of the problem for oil prices. These are the shale companies that are being punished due to their success. This is also the area most feared, as the fall in oil prices could push a lot of these below profitable levels. As this segment presents the largest risk reward tradeoff, we will give the most focus to these companies. Out of the six groups, this is the largest data set of 29 different companies.

Unlike the majors, there are some definite standouts in this data, most notably:

Oasis Petroleum (OAS)

Triangle Petroleum Corp (TPLM)

Occidental Petroleum Corp (OXY)

ConocoPhillips (COP)

Marathon Oil (MRO)

Southwestern Energy Co (SWN)

Suncor Energy (SU)

EOG Resources (EOG)

Considering the valuations of Cabot (COG) and Continental (CLR), it does not make sense that the former companies should be selling at the current prices. Other than TPLM and OAS’s Debt/Equity above one, the remaining six companies have low debt levels and high ROE compared to their peers.

Another thing to note here is that out of the entire list of companies, only 6 of the 29 companies have positive Free Cash Flow (FCF) Yields, which is calculated as FCF/price. This means that almost every company is pouring cash into their business to grow in the future as their CapEx is greater than their Operating Cash Flow. In order to sustain these investments, it must be funded with debt as the business is unable to provide the cash needed. At some point, this may become unstable and is why we need to keep an eye on debt levels. There is a real risk that some of these more leveraged firms collapse as oil prices fall. Due to this, it would probably be best to ignore any company with Debt to Equity above one and negative ROE. To recap here were the six companies with positive FCF Yields:

Suncor Energy Inc. (SU): +4.05%

Occidental Petroleum Corporation (OXY): +3.7%

Marathon Oil Corporation (MRO): +3.61%

ConocoPhillips (COP): +1.15%

EOG Resources (EOG): +0.92%

Southwestern Energy Co. (SWN): +0.6%

Now, let’s look at the hypothetical breakeven points for these companies. I have come across two break even analysis and will share them below. The first is a geographic break even based on where each company has their acreage at. The second is an excellent piece of research from the brokerage firm ITG on the Eagle Ford shale area.

The first analysis is data gathered from Reuters on analyst targets across multiple research firms. Naturally the breakeven points differ wildly, but it is good to know an approximate breakeven for the geography. You can see the Reuters article HERE. Even though targets differ wildly, the general consensus is that the group average is around $60-$80 per barrel of oil even though there are some breakeven as low as $30-$40 per barrel. To add a little bit of color to this, I took a map of the U.S. shale areas from the EIA and tagged the companies to the areas where their significant acreages are. See below:

Something I did notice from this research was that out of the ten producers in the Bakken area, nine of them were in the top 12 companies in ROE out of this analysis. The sample size is not large enough to draw any conclusions from it, but it is was an interesting observation regardless as it conflicts with the Reuters article that suggests that the Eagle Ford has a lower breakeven point than the Bakken.

The second analysis is an in depth presentation over the Eagle Ford shale area by the firm ITG. Their presentation can be found HERE. The important part is slide seven, where it shows the breakeven for all the different firms in the Eagle Ford. Here were the low cost producers:

EOG Resources (EOG): $51

ConocoPhillips (COP): $54

Rosetta Resources (ROSE): $56

Comstock Resources Inc. (CRK): $57

Carrizo Oil & Gas Inc. (CRZO): $57

Chesapeake Energy Corporation (CHK): $59

It appears that multiple companies have appeared repeatedly throughout the analysis. ConocoPhillips (COP) and EOG Resources (EOG) appear to be best in breed and I will do an in depth independent analysis on both firms in a different article. From the map above, COP is in every major shale area except for the Marcellus, and EOG has a stronghold over Texas. Both firms have ROEs above 15%, are geographically diversified, and have low debt levels compared to their peers. Other notables within this sector that deserve further research include OXY, SU, SWN and MRO.

Oil and Gas Drillers

Next we will focus our attention on the oil and gas drillers sector. This area, as one might expect, is a headwind to oil prices as this sector is at the mercy of the oil company’s CapEx budgets. We can see from the E&P analysis, virtually every company has a negative Free Cash Flow (FCF) Yield meaning that they are spending money drilling new wells. According to the Baker Hughes Rig Counts North America is up 1.42% from a week ago and 11% YOY.

With the discovery of the shale areas, horizontal rig use has expanded exponentially over the last decade. Since the year 2000, horizontal rig counts have increased by a staggering 2307% as of November 2014. It has grown from only 5% of total rigs to 71% of total North American rigs. Even though they are typically more expensive than vertical rigs, it enables the technology for hydraulic fracturing to occur and is needed for the shale areas. Another key note is land versus water rigs. Land rigs are up 10.62% YOY where Inland Water rigs are down 37% and Offshore rigs are down 7% YOY.

Now as this chart suggests, this sector of the oil and gas area can be the victim of huge boom and bust cycles. The question that comes into play is can we sustain these rig levels with oil prices falling? Probably the most important aspect in this sector to understand is the oil rig contracts themselves. It is estimated that around 70% plus of all rigs are on long term contracts averaging close to three years. These contracts are priced as a set day rate meaning that the producer owes the driller a set amount each day the drill is in operation, whether it produces a functional well or not. This creates stability in an otherwise extremely cyclical market. However this also means that it will often times lag what is actually happening in the market. If we see CapEx slashed in producers’ 2015 budgets, rigs will start to decrease across the board.

That being said, it is possible to determine the best in breed within the sector. First of all, rig utilization and contract analysis is needed. The firms that have the highest % of their fleet in long term contracts will feel the least pain. Another important factor to look at is what ages the company’s fleet is in. If the company has an inventory of older rigs, it is possible they will not see renewals on those some of those contracts as they come up for expiration. As a caveat to this, if you can find the payback and IRR on these drills it would be a leading indicator for who the best in breed would be.

Below are the eight companies in our oil and gas drillers:

Here we do see strong correlations between ROE, P/BV, and D/E. High ROE and low debt levels equates to premium valuations within the group. At first glance, Helemerich & Payne (HP) appears to be overpriced to the group, however upon further analysis probably deserves the premium valuation as the company has zero debt and is one of two free cash flow positive companies within the group. The other interesting outlier is Seadrill (SDRL). Considering that the chances of a company selling at a P/E of 2 with a ROE of near 50, I figured there was something wrong with the financial data on SDRL. There would be no possible way that a company would be selling so cheap otherwise.

Probably the biggest risk factor facing this group is their dividend commitments. This group is known for high yield stocks and there is a real possibility for some of these names to slash their dividend dramatically. If this was to happen, their stock prices would collapse as that is the major reason most investors hold these stocks. From the data above you can see that Ensco (ESV) has a payout ratio of 132%, meaning for every dollar in Net Income the company brings in it pays out $1.32 in dividends. This is simply not sustainable over the long run. Transocean (RIG) is even worse. Even though the payout ratio above is blank, RIG currently has an EPS of -$2.61 and it pays out $3.00 a share in dividends. That means that currently, RIG is running a $5.61 deficit in cash this year to keep the dividends flowing. The rest of the group seems ok with Nabors and Diamond Offshore having the lowest payout ratios, which also coincidentally are the lowest yields. Also, it appears as of this writing, SDRL is down 11% after hours because they announced they are cutting their dividend.

This sector of the market has arguably been hit the worst over the entire oil and gas universe. In the rig count data above, it appears drilling activity anywhere outside the major shale areas appears to be in steep declines. Therefore if you want to invest in this area, it is probably best to focus on the land drillers and not the offshore plays. If I was to select a stock out of this group it would probably only be HP as they have no debt and is primarily a land driller. In the future, I plan on doing a full article dedicated to Helmerich & Payne as I believe there are multiple competitive advantages that they bring to the table, on top of being rock solid financially.

My Conclusions

With the steep drop in oil prices over the past few months, we have seen the entire oil and gas sector collapse. While this information is true, there are winners within this universe that we can pick up out of the ashes at cheap prices. Just because oil prices drop, does not mean that all companies become unprofitable. It appears that we won’t see a rebound in oil prices for at least 12-18 months, so we will have time to look at these companies in depth to determine who these best in breed are. Most of these companies are great dividend payers and the shale revolution is far from over. The strategy is to invest counter cyclical so we can pick up on these companies cheap, and when we see $100 per barrel oil again, we should be up substantially in these positions.

Disclosure

As of this writing, the author is currently long COP, EOG, TPLM, and HP.