The oil and gas industry desperately needs higher prices

Equities 7 minutes to read

Peter Garnry

Head of Equity Strategy

Summary:  Natural gas prices went below $2/MMBtu in today's session in almost unbearable territory making it even worse for the industry to service its debt and deliver returns to its shareholders. The energy sector has been structurally weak after the financial crisis with too high cost levels and debt overhang to deliver return on capital levels above the cost of capital. This is clearly unsustainable and the industry desperately needs higher prices or else bankruptcies will force the discipline and reign in supply to increase prices. Inflation might be the unpleasant force lurking underneath the unsustainable oil and gas industry.


The oil and gas industry is in trouble seen by the latest restructuring attempt by Chesapeake Energy and this weekend that McDermott International is preparing to file for bankruptcy. As we talked about in today’s Market Call natural gas prices went below $2/MMBtu in today’s session during what should have been the strong season and with the frightening outlook that the US gas industry is running out of time to get “its” winter. The troubles are evident despite low rates and a world economy still in expansion mode. Five years of walking in the desert could the energy be close to an important inflection point with rising prices and profitability?

Structural break since 2008

One of the key observations in the global energy sector is rising cost structure in the sector. During the period 2003-2008 the sector delivered easily +15% return on equity (ROE) but post the financial crisis we observe a distinct lower profitability at equal oil price levels. Take today’s Brent crude price of $65/brl and compare the two periods. In the early period the sector delivered +25% ROE at these price levels whereas the most recent period the ROE has been closer to 5-10%. These returns are not enough to satisfy the required rate of return from investors given the general equity return required and then adding sector risks such as cyclicality risk, elevated credit risk, “black” energy discount etc. The sector is essentially destroying capital at current levels and investments made for new discoveries have also been reduced substantially.

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.

Source: Bloomberg

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.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

Saxo Capital Markets HK is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo Capital Markets HK Limited holds a Type 1 Regulated Activity (Dealing in securities); Type 2 Regulated Activity (Dealing in Futures Contract) and Type 3 Regulated Activity (Leveraged foreign exchange trading) licenses (CE No. AVD061). Registered address: Rooms 2001-02, 20/F York House, The Landmark, 15 Queen's Road Central, Hong Kong

By clicking on certain links on this site, you are aware and agree to leave the website of Saxo Capital Markets, proceed on to the linked site managed by Saxo Group and where you will be subject to the terms of that linked site.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

Please note that the information on this site and any product and services we offer are not targeted at investors residing in the United States and Japan, and are not intended for distribution to, or use by any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation. Please click here to view our full disclaimer.