- Will This Energy Downturn Be More Like 2001 Cycle?
- Quality Differentials And Oil Investment Traps
- A Funny Thing Happened Getting To Earnings Season
- Total Leads Energy M&A Energy Restructuring Charge
- Canada’s Lost Winter Drilling Season
- Random Thoughts About Energy Markets
Note: Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that I feel have potentially significant implications for executives operating oilfield service companies. The newsletter currently anticipates a semi-monthly publishing schedule, but periodically the event and news flow may dictate a more frequent schedule. As always, I welcome your comments and observations. Allen Brooks
Will This Energy Downturn Be More Like 2001 Cycle? (Top)
We have postulated that the current energy industry downturn underway will follow more closely the pace of the 1980s recession-related downturn, which ended the gigantic energy industry boom that dominated the years from the early ‘70s to the mid ‘80s. As we have pointed out in numerous Musings articles the 1970s boom propelled the oilfield service industry and its member company stock prices over that decade to the top performing sector in the stock market.
The length of the ‘70s cycle and the heights to which oil and gas prices rose during that period created a euphoric environment that drove investors to throw money at companies in the belief that the boom would never end. In 1970, crude oil changed hands at $1.80 a barrel, but 10 years later buyers had to pay $36.83 for a similar barrel, more than a 20-fold rise. The Malthusian belief, expounded elegantly by the Club of Rome in its book, The Limits To Growth, held that the world contained a finite amount of raw materials and the increase in the population was straining our ability to support people. That belief seemed to be demonstrated by the periodic, politically-driven oil supply disruptions that rocketed oil and gas prices upward and created outsized cash flows that producers, as we later found out, were ill-equipped to reinvest profitably.
Following almost two decades of stagnant or declining oilfield activity in the
when the equipment was either sold or became part of a new publicly-traded entity. Little did company managers, commercial bankers or investors realize that the seeds of the cycle’s demise had been sown when OPEC initiated its 1973 oil embargo against western countries supporting Israel during its six-day war against its Arab neighbors. These seeds of energy demand destruction were nurtured by ever-escalating oil and gas prices, partly encouraged by ill-timed and ill-conceived regulation designed to protect American consumers from the full impact of higher commodity prices.
When the bust began, it was thought to be merely a slowdown following years of exploding growth. But as demand continued to erode and new global oil supplies arrived in the market as a result of the higher prices of earlier years, OPEC’s share of the world oil market shrank. Many OPEC nations were unwilling to cut back their production to support high oil prices, so what started as a market retrenchment eventually became a full-scale market rout. The drunken oilfield service industry suffered a hangover from too much equipment for the next 15 years. The fallout from this overhang was the ultimate restructuring of the industry through bankruptcies, mergers and liquidations.
Today, the recession engulfing an increasingly large number of major economies around the world is creating speculation that this energy industry downturn will mirror the great industry bust of the mid 1980s. Analysts and investors are wrestling with trying to predict the ultimate bottom for this cycle and the shape of its recovery. In order to do that, they are hauling out all their old data and charts looking to find previous downturns against which to compare current industry statistics. Trying to figure out the road map for the current downturn was helped along by several of the oilfield service management teams during their fourth quarter earnings conference calls in recent days.
On the Halliburton (HAL-NYSE) earnings call Tim Probert, the company’s Executive Vice President, Strategy and Corporate Development, suggested this downturn, as far as the domestic rig count is concerned, would track more closely the pattern of the 2001 downturn. We thought that an interesting observation so we examined more closely what happened to the rig count during that time period and how this downturn was tracking that past record.
The rig count fell from its peak in the third quarter of 2001 and bottomed at the start of the second quarter of 2002 for a three-quarter contraction. From the peak to the trough, the domestic rig count fell by 43%, or 555 rigs. In the current downturn, the rig count peaked late in the third quarter of 2008 and is still declining. So far, we are in the third quarter of the correction with few signs on the horizon for any let up in the decline. This downturn has seen 516 rigs idled so far, but that only represents a 25% retrenchment. If this downturn were to match the 2001 decline, there would be another 357 rigs yet to be idled. Matching the 2001-2002 rig count decline, the domestic drilling industry will lose 873 rigs from the rig count that peaked at 2031 active rigs last fall. The magnitude of that decline would pretty closely match the estimate suggested by Nabors Industries (NBR-NYSE) late last fall and our own forecast in November.
Exhibit 1. Current Downturn Matches 2001-2002 Correction
Source: EIA, PPHB
The more interesting assertion by Mr. Probert was that we would see a natural gas production response to the falling rig count as early as in the second quarter of this year. His assumption is predicated on the base decline rate for natural gas production of 30% a year. Given the growing share of domestic gas production represented by unconventional gas resources – the various gas shale plays – and their production profile, however, it is hard to see a quick downturn for gas production. To see what happened in the 2001 downturn we examined natural gas production (withdrawals from natural gas wells) per day and compared it to the average number of rigs reported to be drilling for natural gas each month by Baker Hughes. We recognize that drilling new wells and gas production are not contemporaneous conditions, but over time the lag should even out.
When you look at the data there is an evident upturn in daily gas production in the early months of 2001. The decline in gas production begins, however, before the peak in gas drilling rigs. What is evident in the data is that the production profile follows closely the downward sloping linear trend line plotted for the entire period. Daily gas production starts to climb above the trend line early in 2007 before jumping up to a much higher level during the second half of 2007. Put us in the camp of skeptics that the current drop in rigs drilling for natural gas will produce a production response by the second quarter as Mr. Probert suggests. We will be happy to be proven wrong in our skepticism as it would signal a positive development for the domestic oilfield service industry.
Exhibit 2. Is Recent Production A Sign of Supply Response?
Source: EIA, PPHB
There are some other considerations about the gas production response and drilling activity that would appear to be supportive of a quick turnaround for the industry. If we look at the trend in daily natural gas production and the number of rigs drilling for natural gas over the time period from 1998 to today there is an interesting dynamic to be noted. Until 2007, daily gas production was essentially flat, but the gas rig count had increased dramatically. If measured from the start of 1998 to the recent gas rig count peak, there had been a roughly 2½ time increase. If, however, you measure the increase from the rig count bottom in 1999, the increase is closer to four-fold. This suggests how much more difficult it has become to sustain, let alone boost this nation’s gas production. This conclusion suggests the recent gas production growth could be at risk if there is a falloff in gas drilling activity.
Exhibit 3. Gas Drilling Increase Recently Boosted Production
Source: Baker Hughes, PPHB
While there may be a gas production response visible in the next quarter or two, we doubt it will be sufficient to lift natural gas prices that are being depressed by the huge volume of gas in storage and the continued growth in new gas supply. Until there is a meaningful reduction in the number of rigs drilling horizontal wells (critical to the success of the gas shale plays) it is hard to conceive of a meaningful drop in gas production due to the production profile for new shale wells. Typically, the production from these shale wells climbs rapidly to a high peak output that may be sustained for some period of time before shifting into a steep decline. The question is whether the producers involved in these gas shale plays who have invested substantial sums in the acreage will be willing to stop drilling and risk the potential for a sharp falloff in their future production, which they will not be able to offset with stepped up new well drilling at a later time. It is quite possible that producers will sacrifice traditional drilling in order to keep their shale gas drilling activity going even though it may add to the industry’s gas supply challenge in a period of weak gas demand. Almost any scenario, however, holds little encouragement for a quick rebound in natural gas prices barring continued cold weather.
Quality Differentials And Oil Investment Traps(Top)
Most people know that crude oil prices are a function of overall supply and demand trends and timing of delivery, but prices also reflect differences in the quality of the crude. We thought about this phenomenon after coming across an investment newsletter that discussed the difference in performance characteristics of various oil-based exchange-traded funds (ETFs). ETFs are investment funds that hold baskets of specific asset classes such as oil service or technology stocks or oil futures contracts and trade on an exchange like a share of stock. The message the newsletter was attempting to deliver was that investors in these oil-based ETFs should understand the differences in their composition in order to maximize investment returns. This is no different than understanding the quality differences among the world’s crude oils.
These crude oil quality differentials are a function of how difficult the barrel of oil is to refine and what mix of products can be extracted from it. The most highly desired barrels are those with high API gravity ratings, which are classified as “light” oils meaning they are relatively easy to refine and produce a significant proportion of high-value transportation fuels. Another valuable quality for crude oil is those that are low in sulfur content, which is referred to as “sweet.” Sulfur is an impurity that must be extracted from the finished product during the refining process and disposed of, adding to the processing cost. The key to the ease of refining crude oil is simply how high the oil must be heated to extract the desired product and whether the resulting product then needs further processing to become marketable products.
Exhibit 4. Refining Needs Heat To Cause Products To Fall Out
Source: EIA
There are about 161 different internationally traded crude oils, all of which are classified by their API gravity rating and their sulfur content. West Texas Intermediate (WTI) is the benchmark crude oil price in the
The other major crude oil that is a benchmark for commodity pricing is Brent Blend. This is actually a combination of crude oil from 15 different oil fields in the Brent and Ninian systems located in the
Globally, the other oil pricing measure that crude oil buyers watch is the OPEC basket price. This price measures a “basket” of seven produced crude oils whose prices are collected by OPEC, including
Today, the world’s oil market finds itself in a super-contango condition. Traditional futures markets for crude oil have a gently upward sloping curve suggesting that oil prices in future time periods will be somewhat more than the nearest month’s price. Currently, that slope has a steep upward bias meaning that near month crude oil prices are much cheaper than future prices, which encourages buyers to take the current output and store it for delivery against a contract some point in the future. As long as the spread between the near-month and the future-month price exceeds the cost of storage, insurance and fees, the buyer can lock in an attractive rate of return on his investment, in some cases as much as 30%. This oil investment letter has been focusing on companies that benefit from this super-contango such as tanker owners and refiners.
They also suggested that investors gain exposure to crude oil through the purchase of oil-based ETFs as another way to capitalize on rising oil prices. The most popular oil-based ETF is United States Oil (USO-NYSE) that trades over 34 million shares per day. The problem is that these ETFs don’t trade oil for a profit, but rather trade futures contracts on oil. That may not be the best way to play the super-contango market, or even the antithesis of contango – backwardation.
USO buys a futures contract for oil for delivery the very next month. Before the contract expires, it is sold and another one purchased for the next month. In a contango market where the near month price is pushed down in favor of future months, USO’s investment returns will be lower. In a backwardation market where the near-month contract is worth more than a future-month contract, USO will generate higher returns. They print in their risk disclosure that contango is not good for their fund. It isn’t good for other ETFs either. The iPatch GSCI Crude Oil ETN (OIL-NYSE) and the Powershares DB Crude Oil ETN (OLO-NYSE) also use the same investment methodology as USO. OLO does actively manage its roll forward strategy to reduce losses.
As the investment letter pointed out, there is a solution to this problem. The United States 12 Month Oil Fund (USL-NYSE), run by the same manager as the USO ETF, runs a fund that uses a 12-month average of futures prices that will lessen the losses caused by a super-contango market. In 2008, and so far this year, an investor would have fared considerably better investing in USL compared to USO. At a recent benchmarking date the performance differential was about 15%. Of course if backwardation were to develop, the USO fund would perform better, but that is a very rare condition in the oil market. So while ETFs have become a popular way to invest in the stock market by avoiding the need to focus on picking individual stocks or specific investment vehicles, understanding their inherent differences from other similar products, much like crude oils, is key to maximizing returns. Remember investment and commodity markets change rapidly so investment returns are not a guarantee of future returns, but if you study the workings of these ETFs you can select the best one for the market environment you expect in the future.
Exhibit 5. Investment Plays On Oil Prices Demand Scrutiny
Source: InvestmentU.com
A Funny Thing Happened Getting To Earnings Season(Top)
Did anyone notice that after the first batch of oilfield service company earnings reports their stock prices actually traded higher? Of the early reporting companies – Schlumberger (SLB-NYSE), Noble Corp. (NE-NYSE), Halliburton (HAL-NYSE), Weatherford (WFT-NYSE), BJ Services (BJS-NYSE), Baker Hughes (BHI-NYSE) and Tidewater (TDW-NYSE) – only Schlumberger missed the analyst projections for its fourth quarter earnings. None of the companies delivered a positive outlook for earnings for 2009, although some were more noncommittal about their future view because they probably do not have sufficient information from clients to be in a position to officially guide earnings lower. So why did stock prices rise?
It seems that when oil prices began their extended and dramatic decline last summer, investors recognized that we were headed for a devastating environment this year. The credit market implosion in September foretold of an impending severe interruption in global trade that would spread the emerging recessions in developed economies to the rest of the world. Investors recognized the changed environment that was emerging and its negative impact on global energy demand. The recent stock price performance would suggest that investors marked energy stock prices down more than may have been warranted.
We found the two-panel chart in Exhibit 6 that shows what has happened to energy stocks since the beginning of 2008. The top panel shows the performance of the S&P 500 Index and the S&P 500 Energy Index since January 2, 2008 through January 27, 2009.
Exhibit 6. Energy Stocks Outperformed Market Since October
Source: The Energy Letter
The two indices were normalized to make the comparison easier to see. The bottom pane shows the ratio of the S&P 500 Energy Index to the S&P 500 Index. Whenever the line increases, energy is outperforming the broad market and vice versa. From the start of 2008, the Energy Index outperformed until July, although the Energy peak actually came in May. From mid-year, both the S&P 500 Index and the Energy Index fell sharply until October. Since early October oil and natural gas prices continued to fall, but the Energy Index began to outperform the broad market. That outperformance accelerated after the beginning of 2009.
If we look at the recent performance of the Philadelphia Oil Service Index (OSX) since the start of November through mid-week last week, we see the index bottomed on December 4th based on its closing price. It actually traded lower during the following day although it closed higher than the prior day. From that point the index began a rally, although it retreated just before Christmas but then continued higher immediately thereafter until peaking on January 6th. The OSX followed crude oil prices lower from that point until the stocks began to rally again the week before last. But importantly, the OSX moved higher on the days when the oilfield service companies were reporting their fourth quarter results. Even after giving downbeat outlooks for 2009, and in some cases disclosing employee layoffs, which certainly signify that managements anticipate an extended business downturn, the stocks were not hurt. This rally in the OSX came despite a pullback in crude oil prices. To us this signifies that investors believe the stock price decline had been overdone despite negative business outlooks for 2009 and weakening crude oil prices.
Exhibit 7. OSX Index Rallied Despite Poor Outlook for 2009
Source: Yahoo Finance, PPHB
Part of what may be going on is another sector rotation within the stock market. There have been several articles talking about the shift of weighting of various stocks within the broad stock market indices. For example, The Wall Street Journal (WSJ) pointed out that the weighting of ExxonMobil (XOM-NYSE) within the S&P 500 Index has grown to 5.6%. The last time a stock had a larger weighting was International Business Machines (IBM-NYSE) in 1985. At that time, investors were hoping that technology would conquer the world. This time, the WSJ believes it reflects a flight to safety. We are not so sure that it doesn’t reflect investor belief that energy industry fundamentals will rebound within the foreseeable future sending energy company earnings back to record levels. Remember, XOM generated the largest quarterly earnings of any corporation in history for several quarters in 2007 and 2008 and is the most profitable company every based on full-year 2008 results.
A recent review of the weighting of the individual stocks comprising the 30-stock Dow Jones Industrial Average (DJIA) shows that the four financial stocks in the index – JP Morgan Chase (JPM-NYSE). American Express (AMX-NYSE), Bank of America (BAC-NYSE) and Citigroup (C-NYSE) – had a collective weighting of 5.4% in the index. An analysis shows that these four stocks account for a mere 400 points of the Dow Jones’ 8,000 points. If all four stocks went to zero they would cost the Dow Jones only 5%. Some other people have suggested that GE (GE-NYSE) should be considered a financial company due to its large earnings component from its subsidiary, GE Finance, but even adding its market weight would only bring the sector to 6.7%. In contrast, XOM and Chevron (CVX-NYSE), the second and third most important stocks in the index, have weightings of 7.5% and 7.0%, respectively.
We looked to see what had happened to the weighting of the 10 industry sectors comprising the S&P 500 Index since the start of 2008. At that time, the financials were number one and energy was third. By mid-2008, energy had moved into second place barely behind the information technology sector, but two percentage points ahead of the financials. The collapse of energy stocks in the second half of 2008 resulted in energy and financials being tied for third place behind information technology and health care. As of January 27, energy was well positioned in third place, some four percentage points ahead of the financials that had fallen to fifth place.
Exhibit 8. Recent S&P 500 Sector Weighting Changes
Source: Standard & Poor’s, PPHB
The significance of the collapse of the financial sector can best be seen by the chart in Exhibit 9. It shows the value of a number of bank stocks and brokerage firms (most have become bank holding companies to be able to tap government bailout funds) as of January 20, 2009, compared to their market value as of the second quarter of 2007, about the time the mortgage credit crisis emerged as a serious financial problem. Today, these companies are a mere shell of their former selves and most are partially nationalized that will likely impact their future valuation, meaning that they have become speculative trading vehicles rather than solid investment candidates. A significant question for Dow Jones is whether they will adhere to their traditional practice of removing stocks that have fallen in price below $5 per share, or whether they will wave that mandate like the New York Stock Exchange has done with its listing requirements, in hopes for a quick recovery so they will not have to rework the DJIA.
The destruction of the financials can best be summed up by the charts in Exhibits 10 and 11 although they only extend through the middle of January. In the first chart, the performance of the financial sector within the S&P 500 Index shows almost an 80% decline since mid 2007, but more importantly it points out that the sector is now back in price to where it was in 1995.
Exhibit 9. Bank Values And Their Franchises Have Collapsed
Source: Infectious Greed
Exhibit 10. The Financial Sector Correction Has Been Horrific!
Source: Bespoke Investment Group
While a dramatic retrenchment, the historic magnitude of the correction become clearer with the chart in Exhibit 11. It puts into visual perspective how even the 1995 price level reflected a historic high for these stocks since before the start of World War II.
As an old securities analyst who began as a bank stock analyst and helped manage a $200 million portfolio of bank stocks in 1970 for a mutual insurance company, what has happened to this sector is almost beyond comprehension. While the financial stocks have rallied in recent days due to hope about the possible creation of a “failed bank” to deal with the bad assets held by financial institutions,
Exhibit 11. Financial Stocks Still At Historical High
Source: Bespoke Investment Group
it is possible the fall for this sector is not yet over. We will have to wait and see. In the meantime, energy stocks seem to have become a more popular place for investors to park their money.
A final thought about investing in stocks. The conventional wisdom is that investors should have well diversified portfolios in long-term oriented funds to protect against the vagaries of certain market sectors being impacted by some external event rendering that industry impotent for generating positive investment returns, or worse to dramatically under-perform the broad stock market. There were times last year when owning energy or financials was the kiss of death for investment results. As last year proved, there was no safe investment asset class. Stocks, bonds, commodities, real estate, venture capital, private equity and even hedge funds were all victims of the 2008 financial crisis. Even cash, depending on which currency you held it in and the level of interest you expected to earn, was not immune to last year’s debacle.
Now we have the latest ex-post facto examination of investment diversification that was supposed to protect investors. Even if one has an investment in a broad stock market index such as the S&P 500 Index, by using an equal-weight version rather than the popular market capitalization weighted one, an investor should be better prepared to weather a market downturn.
In the equal-weighted S&P 500 Index, each stock would represent a 0.2 percent position in the fund. In contrast, the traditional S&P 500 Index weights stocks by their market capitalization, thus giving greater importance for performance to the bigger stocks. The equal-weight index protected an investor better than the traditional S&P 500 index during the internet bust commencing in March 2000. By the end of 2003, the S&P 500 was down 30% from its high while the equal-weighted version was up 16%.
During the market rally of 2003-2007, the equal-weighted index beat the traditional S&P index, but then fell more in the 2008 downturn. From its peak in late 2007, the equal-weighted index was off 48.5% compared to the 42.3% fall registered by the traditional S&P index. According to money management firm Grantham Mayo Otterloo, the MSCI World index of developed world stocks fell 49% during the sell-off, the same as the market capitalization weighted version of the index. The odds were that the main index would suffer a fall like this about once every 100 years. The odds it would happen to the equal-weighted index are once every 34,000 years. Hopefully this data will give some solace to investors as they open their 2008 year-end investment statements and recognize that they have been a part of a black swan event.
Total Leads Energy M&A Energy Restructuring Charge(Top)
Barely a month into the new year and with most energy investors wrestling still trying to figure out just how conservative oil company CEOs are going to be in this unsettled economic and credit environment, along comes Total (TOT-NYSE) with an unsolicited C$617 million ($510 million) buyout offer for Canadian oil sands player, UTS Energy Corp. (UTS-TSX). The target company’s major asset is a 20% stake in Petro-Canada’s (PCZ-NYSE) planned Fort Hills’ project. The remaining 20% interest in the project is held by Canadian mining company, Teck Cominco (TCK-NYSE).
The Fort Hills project’s latest estimate is that it contains 4 billion barrels of recoverable bitumen. The project is targeted to come into production in two phases, each with capacity of 160,000 b/d. The first phase has already received its official approvals, but the owners are having the engineering and design proposal re-evaluated in light of changed oil prices and capital and operating costs estimates. The go-ahead decision is anticipated sometime in 2010 with start of production during 2013. The Fort Hills project is located in the Athabasca region of
Total is offering, through its Canadian subsidiary Total E&P Canada Ltd., to pay UTS shareholders C$1.30 per share all in cash. The offer price represented a 57% premium over the closing share price on January 27th and a 51% gain over the weighted average trading price for the last 30 days. Already, I.G. Investment Management, which holds about 22 million UTS shares, said it will not tender its stake. One of the firm’s managing partners said the offer was well below the C$2.50 per share or higher price that the fund manager has estimated as a minimum value for UTS. Another fund, West Face Capital, Inc., which owns about 10% of UTS shares, has also said they will not tender any as they see Total’s move as an opportunistic, low-ball bid for the oil sands developer. They suggest the minimum price is C$2.60 a share, with the amount of value above that price debatable.
Exhibit 12. Fort Hills In Oil Sands Development Mix
Source: Rigzone
Analysts and investors have suggested that the combination of the credit crisis and the global economic downturn will reshape the energy industry. The fall in
The big question is whether this move marks the start of a tidal wave of buying of smaller oil and gas exploration and production companies by larger industry players. As stock prices for these small companies have bounced off the bottom of their correction, but not bounced very high, they represent attractive levels at which larger buyers can make offers with substantial premiums over existing stock prices to current owners while still acquiring key assets at relatively low valuations. We are not sure that many IOCs will be active players in the present environment, at least until they gain greater confidence in the length and depth of the global recession and the trajectory for future oil and gas prices. NOCs, or quasi-NOCs, may lead this parade of acquirers as their motivation and purchasing parameters may differ significantly from those of the IOCs.
We recently led a panel with Tim Probert, Executive Vice President, Strategy and Corporate Development for Halliburton discussing the merger and acquisition (M&A) environment for the oilfield service industry at the Mergermarket Energy M&A ‘09 conference. As we pointed out to the audience, last year was an active one in terms of the amount of money spent in oilfield service M&A deals, but that figure was influenced by the high premiums paid for the buyout of richly valued publicly-traded service companies acquired. As the data in Exhibit 13 shows, for the high profile/high valued deals, many of them were actually agreed to late in 2007, or early in 2008, before industry and investment markets changed. Fortunately all of these deals were closed contrary to a large number of deals in general industry that could not get financing and subsequently failed prior to being closed. An interesting analysis of M&A deals we found showed that in the March to July period of 2007, the end of the bull stock market, there were 62 buyouts of which 57 were competed, two failed and three have still not closed. In contrast, in the June to December 2008 period, or during the depths of the stock market collapse, there were only 36 deals, but 25 closed while three failed and eight are still pending. The interesting number is a 2-1 ratio of the average number of buyouts per month in the bull market versus the bear market.
Exhibit 13. Oilfield Service M&A Activity Was Active Last Year
Source: PPHB
It was interesting to examine the nature of oilfield service M&A transactions completed last year. Three of the deals involved private equity buyers looking to acquire high quality international franchise companies that could become platforms for building much larger companies in the future through additional add-on acquisitions and accelerated investment. The remainder of the deals involved large industry players buying businesses that helped them to expand their franchises either geographically or product wise. We believe that the oilfield service M&A market is now primed for strategic buyers to fill out their business portfolios with either specialized (niche) product and/or service acquisitions or geographic expansions for existing operations. We also think that the absence of credit markets hurts the competitiveness of private equity buyers in bidding against strategic buyers because the private equity model requires leverage to make it work.
Exhibit 14. Oil Service M&A Is Slow, But Poised For Change
Source: PPHB
Probably the prime challenge for the M&A market today is not securing debt, but rather closing the valuation gap between the buyer and seller. The latter is still living in the world characterized by the boom of the first half of 2008 while the former is envisioning the bust associated with current depressed stock market valuations. As we show in Exhibit 15, the valuation of all M&A deals has risen and fallen over time in keeping with changes in the valuations reflected in the public equities market. We also show the valuations for oilfield service deals that have traditionally lagged those of the overall M&A market. In 2008, oilfield service valuations rose despite there being fewer deals and in the face of collapsing oil and gas prices in the second half of the year along with energy company stock prices. What the higher 2008 oil service valuation reflects is the substantial premiums paid for the buyouts of already highly-valued public companies. That is probably an anomaly not to be repeated soon.
The gap between buyers and sellers today resembles the
Exhibit 15. M&A Values Rise And Fall With The Stock Market
Source: Capital IQ, PPHB
Canada’s Lost Winter Drilling Season(Top)
Recently the rig count in the Western Canadian Sedimentary Basin (WCSB) stood at 465 active rigs, which yields a 55% utilization of the available rig fleet (858 rigs). In the comparable week of 2008, there were 607 rigs working for a 70% utilization rate. The weakness in
Exhibit 16. 2009 Rig Activity Is Tracking Lowest Of 2000-2008
Source: Baker Hughes, PPHB
Eleven years ago, according to the Canadian Association of Oilwell Drilling Contractors (CAODC) drilling rig data, there were about the same number of working rigs as now. Today those working rigs represent about 55% utilization of the total rig fleet versus a 66% fleet rate in the earlier period. That 11 percentage point spread in fleet utilization rates can be the difference between profits and losses for drilling contractors. An equally important consideration is which rigs are bearing the brunt of downtime. It appears that the shallow rig portion of the fleet is most impacted in this downturn.
We were thinking about this data as we listened to the editors of World Oil magazine presenting their industry outlook last Friday. According to them,
The World Oil forecast is not significantly different from the Oil & Gas Journal forecast published in mid January that was based on the forecast from the CAODC, which predicts a 7.8% decline from 17,703 wells in the WCSB to 16,290 wells in 2009. (We suspect the count difference may be due to the determination of when a well is completed.) The critical ingredient in both forecasts is their rig count assumptions for 2009 along with the distribution of the rig activity throughout the year and what types of rigs will be most active. The Canadian petroleum industry drills about 40% of its total yearly wells during the winter drilling season. With the rig count off so much this winter, it is hard not to foresee a sharper decline in the number of forecasted wells to be drilled in 2009. That is especially true when one considers that the shallow-depth rigs often drill the lion’s share of the wells drilled during the course of the year.
The World Oil editors pointed out that a contributing factor to the larger well decline this year than last year is the cutback in activity in the oil sands region. To impact the rig count forecast, the cutbacks need to be in extraction projects employing steam assisted gravity drainage (SAGD) technology. Here two wells are drilled parallel at each other at different depths so that steam can be injected into the upper well to heat the bitumen that then drains into the lower well and is pumped out. While there have been about $90 billion of oil sands projects delayed, postponed or outright cancelled, many of these projects employed conventional mining rather than SAGD extraction. We are sure there are some SAGD projects impacted, but we don’t know how many. Bottom line is we are not sure that their forecast isn’t overly optimistic. However, if World Oil’s $88.50 a barrel oil and $6.27 per Mcf of gas price forecasts for 2009 prove correct, there will be some very high oil and gas prices experienced during 2009 that will definitely pump up drilling activity.
Random Thoughts About Energy Markets(Top)
$400 Million For Global Warming Research(Top)
We were mystified by President Obama’s and the Democratically-controlled Congress’ plan in the economic stimulus bill to give $600 million to the National Aeronautical and Space Administration (NASA) that includes $400 million for advancing the study of global warming. Not only will there be more scientists hired to study the issue, but NASA will spend more on “satellite sensors to measure solar radiation critical to understanding global warming.” This language comes from the Summary: American Recovery And Reinvestment Bill of 2009 issued by the House Committee on Appropriations on January 15, 2009.
We are wondering why the need to spend this money if, as Al Gore proclaimed in his movie An Inconvenient Truth: “The debate is over!” This statement, and variations of it, became popular after Hurricane Katrina roared through
“Stick-in the-mud” Exxon Mobil Corp. Outflanks Its Competition(Top)
We have a pet descriptive phrase for energy executives who do well in rising commodity price markets but not so well in the down legs of their industry business cycles – downhill bike riders. Last year we experienced a dramatic shift from the bullish phase of the energy cycle to the bearish phase. In 2009, we will begin to see who fits our description. One management that won’t is the executives running the world’s largest and now most profitable oil company – Exxon Mobil Corp. Prior to last summer, ExxonMobil was viewed as a super conservative oil company that couldn’t think beyond oil and gas – missing the new wave of alternative fuels. Environmentalists attacked the company for failing to embrace green technologies. Motorists and
What we missed were the laudatory articles about ExxonMobil being the most profitable company ever. We also missed the analysis of all the billions it could have made last year, but didn’t because it adhered to a stricter standard in managing its affairs – trying to maximize free cash flow while continuing to investing in projects that would extend the company’s successful financial model well into the future. Last year, ExxonMobil returned $40.1 billion to shareholders through stock buybacks and dividends, or 154% of its exploration and capital spending. This topped its competitors Royal Dutch Shell (RDS.A-NYSE) at 37%; BP at 61%; Chevron at 67% and ConocoPhillips (COP-NYSE) at 87%.
ExxonMobil is well positioned compared to many mid-tier oil competitors that have had their cash flow evaporate just when they need to fund expensive new field developments. The company today is positioned very much like a classic value investor. It was fearful about buying when others were greedy, and now it has the cash to be greedy when others are fearful. Is petroleum industry M&A on the way?
Will You Need A Clothespin For Your Nose When Visiting Oslo?
Biomethane is a by-product of treated sewage. Microbes break down the raw material and release the gas, which can then be used in slightly modified engines. In
The city’s diesel buses will only require minor modifications to their engines to run on methane, which is stored in tanks on top of the vehicles. The net emissions from a biomethane operated bus are zero, because the carbon originally came from the atmosphere rather than fossil fuel. However, electricity is used at the sewage plant to convert the gas from the waste into fuel, so the
If the biomethane project proves successful,
Baltic Dry Index Rally A Sign of Economic Recovery?(Top)
Most of the economic news in recent weeks has been dismal, although some investors welcomed the preliminary fourth quarter of 2008 U.S. GDP estimate of a decline of only 3.8% as a positive because it wasn’t the 5% or 6% declines expected by most economists. The latest data from the International Air Transport Association (IATA) said that while international passenger traffic grew 1.6% last year, down from the 7.4% growth of 2007, it fell in December by 4.6%. The shocking statistic, however, was for air cargo, which fell by 4% during 2008; but collapsed in December by 22.6%. Giovanni Bisignani, IATA’s CEO, said, “The 22.6% freefall in global cargo is unprecedented and shocking. There is no clearer description of the slowdown in world trade. Even in September 2001, when much of the global fleet was grounded, the decline was only 13.9%.”
Exhibit 17. Baltic Dry Index Rally Signaling Trade Recovery
Source: Bespoke Investment Group
With air cargo trade collapsing, and according to IATA it accounts for about a third of the value of goods traded internationally, we were surprised to see that the Baltic Dry has been on the rise. The index fell some 94% from its high in May 2008 to its low in early December. Since then, as shown in the right-hand chart in Exhibit 17, it has climbed 53% from its 650 low. Since that chart was published through the end of January, the index has climbed an additional 5.6%. The Baltic Dry Index is a measure of freight rates for ships hauling raw materials in bulk. Some might say that shipowners have taken vessels out of service thereby tightening the market, but from anecdotal evidence we have received, it seems that possibly
While the move in the Baltic Dry Index doesn’t mean there is an impending recovery in global economic growth immediately ahead, it offers the hope that commodity markets might be coming closer into balance such that only small increases in demand will trigger price recoveries. We think that may be part of why oil prices are holding up better in late January, even though they declined 14% during the month. That decline probably says more about traders having driven the price up to high during the holiday rally taking advantage of an illiquid market and short-covering by traders at year-end. We will be watching the Baltic Dry Index for further signs of confirmation of a nascent trade recovery.
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Parks Paton Hoepfl & Brown is an independent investment banking firm providing financial advisory services, including merger and acquisition and capital raising assistance, exclusively to clients in the energy service industry.
