Financial Analysis of Oil and Gas Market – January 2017

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It will not surprise any investor in oil and gas and related businesses that theirs is a cyclical business. Prices run up when supplies fall short of demand, hover around peak for a few years, then tumble as new supply sources are developed and demand growth slows down. 2016 has not been an easy ride for anyone at any level in the industry. Last year would have been an epic fail had it not been for the Saudis cutting 1.2m bpd, Iraq reducing output by nearly 20%, and Russia leading the non-OPEC contingent’s deal that followed a few days later – with a cut of around 300,000 bpd. Traders were happy, Nigeria and Libya were thrilled that they didn’t have to do a thing and we could finally move into 2017 with a little jump in our steps.

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Bubble size represents market cap

FIGURE 1: PERFORMANCE OF OIL AND GAS COMPANIES

Description: Figure 1 highlights the performance of the oil and gas industry for the month of January 2017 (x-axis) and the performance of the 11 months prior to January 2017.

So what should we expect with President Trump at the helm? One thing is for sure, OPEC’s agreement to reduce production with apparent support from Russia will be tested by inducing expansion of U.S. shale production. The past eight years have seen a series of rules designed to suppress coal use, to the benefit of natural gas as well as renewables. The new administration may choose not to defend constitutional challenges by various individual states. There may also be a reduction in subsidies and mandates favoring renewables, but natural gas will likely find it difficult to displace coal at the pace seen in recent years.

For upstream companies, we expect a more conservative approach to strengthen balance sheets, sustain dividend payments and drill within cash flows. The sudden oil price slump brought about a change in the industry when it comes to long-term investments. We estimate more than $500 billion of projects through 2020 to have been cancelled or deferred as a result of the downturn. Also, the industry’s appetite for long-term capital projects has waned, despite a few exceptions.

Meanwhile, M&A activity in the oil patch hit $69 billion in 2016, more than double the total in 2015. The biggest contributor to the reversal was the Delaware Basin, a portion of the larger Permian Basin located in Texas and New Mexico and the Midland Basin, another section of the Permian. The Permian’s low break-even costs are prized with crude prices still stuck at $50 to $60 per barrel. In 2017, we believe that acquisition activity will pick up even more and expand beyond the Permian to other proven plays that are economic at above $50 a barrel.

The oilfield services sector has been hammered by the downturn and will likely consolidate further. The question to be answered is whether the consolidation will be lateral or vertical. So far, Schlumberger and Technip have taken to lateral extension by acquiring Cameron and FMC Technologies, respectively, and the forthcoming merger between GE Oil & Gas with Baker Hughes is also mainly lateral extension of business lines.

Midstream companies should be able to resume organic growth as companies invest in energy infrastructure, aided by a supportive rather than hostile federal government and underwritten by producers seeking access to liquid markets.

Investors in the market are still quite cautious, but confidence is building as we move through 2017. Much of the $100 billion in investment capital that private equity firms had on hand at the start of 2016 is still available as well and Wall Street is eagerly looking to invest in secondary stock offerings from drillers looking to fund large projects.

To attract investors and create value for shareholders, companies can leverage new technologies, simplify their organizations to improve productivity, partner creatively with equipment and services providers and make acquisitions while prices are still relatively low. We believe this is still a good playbook for well managed companies.