Bearish News Aplenty

Back in March, with West Texas Intermediate (WTI) crude trading in the $40s, there was a lot of hand-wringing over the status of U.S. oil inventories, which were high and rising. A number of analysts were predicting that the inventory situation would inevitably lead to prices plunging to around $20/bbl. At that time, I wrote a series of articles explaining why inventories were likely to peak soon, and why the price of crude was likely to rise. Indeed that is exactly what happened. Crude inventories fell for eight straight weeks, and the price of WTI reached $60 before pulling back.

Now, however, there is a perfect storm of bearish news that may very well result in oil prices revisiting the lows from earlier in the year. The ongoing crisis over Greek debt affects oil prices in two ways.

One is the potential fallout for Europe’s economy. The deal reached Sunday doesn’t really resolve the weaknesses and contradictions plaguing Europe’s deeply flawed union. Greece consumed just 0.3% of the world’s oil supply in 2014, but the EU accounted for 14% of the total, and Europe’s economic recovery remains fragile.

Another issue is the effect that a temporary resolution of crisis might have on the dollar. If investors come to believe that the Federal Reserve will now feel freer to raise rates this fall as a result, the dollar could continue to strengthen. This would make oil more expensive on the global market, as most of the world’s oil is traded in dollars. A stronger dollar therefore gives rise to concerns that the potential softening of demand growth will extend well beyond Europe. As a consequence, stocks that are particularly leveraged to oil prices — in particular those of the drillers with a heavy percentage of oil in their production portfolio — have been pressured.

Refiners generally benefit from lower oil prices, and integrated oil and gas companies are more insulated from the oil pain thanks to their refining operations. The midstream companies and MLPs are in a similar situation: they have some protection from low oil prices but are not entirely immunized against them.

The Greek debt crisis is one of several items pointing to softer oil prices for the rest of this year. Should nuclear talks with Iran result in an agreement, Tehran could potentially put nearly 1 million barrels per day (bpd) of additional oil exports onto the market within the next 12 months. While OPEC could make adjustments by limiting its output, in recent months the Saudi-led exporters’ group has done just the opposite — reportedly producing 1.3 million barrels above its official production target of 30 million barrels a day. This is the highest level of OPEC production in nearly three years. OPEC’s heavy output is likely a continuation of its strategy of keeping pressure on shale oil producers.

Speaking of which, this past week the U.S. rig count actually rose by 12 after 29 straight weeks of decline. Oil production in the U.S. had been showing signs of slowing, but the increase indicates that some shale oil producers at least expect to make money even at these prices. The notion that U.S. shale oil growth may continue is another factor that helped send WTI down nearly 8% in a single day a week ago; prices have so far failed to recover.

US crude oil inventories are still historically high, and after eight straight weeks of decline they have now increased for two weeks in a row. This once again has traders nervous about the crude stockpiles. The market for WTI remains in contango; the August 2016 contract is trading for $4.5/bbl above the front month contract. This is roughly the cost to store oil for a year, so the contraction or expansion of the spread in prices over the next few months will likely dictate what happens with crude inventories.

The final factor weighing on oil prices currently is the fear of an economic meltdown in China following a spell of panic selling in China’s stock market. China accounted for nearly half of the world’s crude oil demand growth over the past decade, and this was a huge factor contributing to the $100/bbl oil prices of the past four years. A major slowdown in China would likely have the biggest impact on crude prices of all the factors discussed here. I still believe crude is unlikely to break below $40/bbl, but a combination of new Iranian oil exports and a slowdown in China’s economy could push prices to that level. Fortunately the long-term correlation between China’s stock market and its economic growth is fairly low.

The good news is that oil refiners continue to show strength. Even though they have pulled back slightly over the past week, our #1 Best Buy Valero (NYSE: VLO) was still up 16% over the past three months, and is over 35% higher year-to-date. Our #3 Best Buy Western Refining (NYSE: WNR) is in our Aggressive Portfolio as it is less diversified than the others, and it is up 25% YTD and 10% in the past 3 months. Our #6 Best Buy Marathon Petroleum (NYSE: MPC) has returned 21% in the past three months and is up over 30% year-to-date.

The refining sector remains attractive despite these gains, which we have forecast for much of the past year. It looks like this will remain the safest bet in energy investing for the foreseeable future. Nevertheless, in today’s issue I am going to turn my attention back to our proprietary stock screening tool to identify some possible bargains among the hard hit oil and gas producers. It’s certainly not too early to identify the most promising candidates that will benefit from an eventual upturn in oil prices.

The Universe of Oil and Gas Drillers

Before digging in, I want to share the list of every oil and gas production company that the screening tool extracts. Note that I have filtered out all but the pure oil and gas producers. Refiners, midstream companies, oil field services, coal companies, and royalty trusts have all been excluded.

I have further narrowed the list by concentrating on the oil and gas producers that reported a Standardized Measure (SM) in their most recent annual report. As you may recall from previous issues, the SM estimates the present value of the future cash flows from proved oil, natural gas liquids (NGLs), and natural gas reserves, minus development costs, income taxes and current exploration costs, discounted at 10% annually. All oil and gas producers traded on a U.S. exchange must provide the Standardized Measure in their filings with the Securities and Exchange Commission, and it must be calculated according to specific guidelines set by the SEC.

However, some companies in this category did not report a year-end SM. In some cases, it’s because the company is in the very early stages of exploration and doesn’t really yet have any reserves. For others, it’s because the company is structured so that it derives its income from oil and gas companies without actually owning any reserves directly. I also removed those companies that reported a year-end SM but are no longer trading as a result of a merger or takeover (e.g., Talisman Energy). Finally, I removed a couple of companies because some of their metrics were nonsensical relative to the rest of the group, indicating a likely problem with the data.

An example of a company that I removed from the table below is Viper Energy Partners (NASDAQ: VNOM), a master limited partnership that was spun off from Diamondback Energy (NASDAQ: FANG) last summer in a $100 million IPO. Viper owns mineral rights in the Permian Basin in West Texas but no actual reserves.

After limiting the list to the pure producers who filed a year-end SM with the SEC, I was left with 114 stocks. They range from ConocoPhillips (NYSE: COP) and its $97 billion of enterprise value to penny stocks like the $10 million Houston American Energy (NYSE: HUSA). Here is the full list in descending order by enterprise value, along with some metrics that should be of interest to investors. Note that there are some traditionally pricier MLPs on the list, so apply caution when comparing the valuation metrics:

• EV = Enterprise Value in billions as of July 7

• EBITDA = 2014 earnings in billions before interest, tax, depreciation and amortization

• SM = Standardized Measure, the present value of the future cash flows from proved reserves as of year-end 2014 in billions

• FCF = Free Cash Flow in 2014 in millions

• Res = Proved reserves in billion barrels of oil equivalents (BOE) at year-end 2014

• Short Int. = Percentage of the company’s shares that have been sold short

• CR = Current Ratio, current assets divided by current liabilities for the previous quarter

• % Gas = Percentage of the proved reserves that are natural gas

In order to appreciate the complete meltdown that took place in the oil and gas industry over the past year, note that 113 of the 114 stocks on the list have a negative total return for the past 12 months. The only exception is Isramco (NASDAQ: ISRL), a small oil and gas producer with properties located onshore in the U.S. and offshore near Israel. The fifth “best” performer on the list for the past 12 months was Growth Portfolio holding Cabot Oil and Gas (NYSE: COG) with a total return of -12.7%.

As I typically do, I included the proportion of natural gas in the reserves because that indicates whether a producer is primarily an oil company or a gas driller. The margins on oil have been better than on natural gas in recent years. I also included the short interest to give an idea of which companies are generating the most skepticism.

These are not all of the financial measures that the screen sorts. In fact, what is shown in the table is less than a third of the metrics provided by the screening tool. But I have to be selective with what I report to keep the table legible. The screen also pulls in detailed information about the nature of the oil and gas reserves — including exploration and production costs — details about short- and long-term debt, profit margins, return on assets, and credit ratings. I make use of this torrent of data as needed.

The average stock on our final list has an EV of $9.8 billion, an EV/EBITDA of 10.4, -$678 million of annual free cash flow, and an EV/Reserves value of $15.92/BOE. The average company also produces less gas (45%) than oil, and has a current ratio of 1.2.

The negative free cash flow isn’t necessarily a problem, because oil companies were investing heavily when oil was $100/bbl. Some are now cutting back dramatically on capital spending and will live off the proceeds of their investments in recent years. But persistent and heavy overspending relative to the cash flow is certainly a red flag.

Narrowing the List

If I were to take this list and try to reduce it to most likely takeover candidates, I would start by screening for those companies with a low EV/EBITDA and low EV/Reserves. If I look at the companies with EV/Reserves values in the lowest quartile — leaving a maximum of $9.43/BOE — and then further restrict that list to companies in the lowest half for EV/EBITDA, I’m left with these names:  

One entry on the list, Eagle Rock Energy Partners (NASDAQ: EROC), is already being acquired. The three companies on the list with the largest reserves — Southwestern Energy (NYSE: SWN), and Growth Portfolio holdings Chesapeake Energy (NYSE: CHK) and WPX Energy (NYSE: WPX) — are predominantly natural gas producers, which helps explain their low EV/Reserves ratios. Of those that are predominantly oil producers, none are currently in any of the portfolios, but some warrant a closer look based on this screen.

To be clear, there are very good companies — and many portfolio holdings — on the larger list. Using different metrics some of those companies will rise to the top of those screens, but different risk levels (e.g., conservative versus aggressive) will generally require a focus on different screening criteria.      

Conclusions

My goal in this article was to introduce investors to the entire universe of oil and gas producers, along with some important metrics for each. I would imagine that there are companies on the list that have never crossed your radar, but our goal is to leave no stone unturned and consider the merits of each company on the list.

To be clear, attractive financial metrics are only one step in the due diligence process. A stock might look cheap because the business is in some way risky or otherwise unappealing. Further, temporary distortion might make an otherwise attractive stock look expensive. It is still important to understand the story behind each company. Our screener is just one of the tools in our toolkit.  

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)