The oil and gas industry desperately needs higher prices

Many value investors have wrongly pointed at low valuation levels and fat dividends as arguments for buying the energy sector. We have basically been negative on the sector since 2015 when prices collapsed and all the metrics became so toxic that the entire operating model became defunct. The last five years have proven that value investors need more than valuations and dividends. If an entire sector is not operating at sustainable and attractive return on capital levels then the sector goes nowhere.  The energy sector has delivered zero percent including dividends the past five years compared to the global equity market up almost 60% in the same period. If we can get the necessary bankruptcies to curb supply instead of relying on OPEC+ then we will endorse the sector with an overweight view, but for now the risks are still too high. But 2020 could be the year where the oil and gas industry becomes an opportunity despite the ongoing flood wave of green investments.

Debt load and inflation

What makes the situation even more dangerous for the energy sector is the leveraging that has accelerated since the price collapse in 2015. For 10 years the sector operated with stable low net-debt-to-EBITDA multiple but after 2015 this metric deteriorated badly and has now settled at levels four times the golden period from 2003-2008. With low rates the sector is barely managing the debt levels but if the world gets higher interest rates the fallout in the energy sector could be severe. What is interesting about the dynamics in the energy sector is that the low interest rates have sustained oil production and increased it substantially through debt financing. This is has caused oil supply to increase to levels compressing the oil price to such levels where the sector suddenly destroys credit and equity value. That’s an irony even in the world of Silicon Valley unicorns descending on Wall Street.

We are likely moving closer to a forced wave of bankruptcies and restructurings that could cause a material slowdown of oil production which would lift prices and profitability for the companies standing up after the reset. But higher energy prices mean higher inflation which could lead to higher interest rates which would then cause distress for more energy companies. A vicious feedback loop could happen. If investors want to get exposure to the energy sector we believe the best way to do it is by getting exposure to the energy companies with solid balance sheet and strong return on capital metrics.

Any way you look at it the industry needs higher prices or some new technology that unlocks efficiency gains that are large enough to operate profitable at current levels. The industry needs sustained oil prices above $80/brl to deliver the return on capital long-term that makes the sector viable for creditors and equity investors.