In The E&P Space, ‘Grow’ Is A Four-Letter Word

03May '18

In The E&P Space, ‘Grow’ Is A Four-Letter Word

Editor’s note: This article first appeared on Seeking Alpha

Summary

  • Growth investors have rotated out of oil and gas equities and have been replaced by value-oriented styles, as exhibited by Range Resources Corporation.
  • Valuation disconnects have attracted activist investors.
  • There are some signs the oil markets have returned to fundamentals, and investors are looking for signs of an upturn.

People often talk about a “sea change” when describing a major change in perception, whether that change is in geopolitics, culture or financial markets. There is no doubt that the oil and gas markets entered new waters on November 26, 2014 when OPEC announced it would not make production cuts to offset growing oil production from other parts of the world, namely from the unconventional resource plays in North America. At that time, market sentiment quickly flipped from oil markets being demand-driven to supply-driven. Ever since, oil prices have fluctuated at levels far below their pre-2014 levels.

The tug-of-war between bulls and bears continues, as increases in the rig count drive supply concerns while drops in crude oil inventories give the bears something to cheer about. Neither side, however, has enough critical mass to drive oil prices convincingly. As investors navigate these turbulent waters, we believe they should be mindful of current investor sentiment and how it impacts E&P and energy-related equities.

One touchstone of how oil executives feel about the market is their Letter to Shareholders found in their annual reports. This year, we have detected a subtle, but significant change in tone and word choice from the C-suite. Companies that would have been otherwise bragging about their production growth rates have toned down use of the “G” word, especially when it is in the context of growing capital budgets, proved reserves and other key measures.

Since when did “grow” become a four-letter word?

Value investors own the conversation

The language has changed because there has been change in who owns E&P companies. Let’s take Range Resources Corporation (NYSE: RRC) as an example. The chart below illustrates the change in RRC’s shareholders with active investment styles from the end of 2014, just after OPEC’s Thanksgiving Surprise, and the most recent reported positions.

At year-end 2014, investors having a Growth, GARP or Aggressive Growth style owned 47% of shares held by active investors (as compared to passive or index funds). As of April 5, 2018, these growth-oriented investors held only 26% of shares held by active investment styles, almost half as much as four years ago. Filling the gap have been Value and Alternative investors, who now own 71% of RRC, up from 51% at year-end 2014.

Based on our analyses, RRC is not an outlier and that the shareholder compositions of other energy names follow a similar pattern. The rotation of growth investors out of oil and gas equities as exhibited by the Range Resources example is emblematic of a larger trend that we see in nearly all E&P and oilfield services companies.

The energy sector has been underperforming the broader market as measured by the S&P 500 index for the past three years by non-trivial amounts. The chart below illustrates that except for the past month, the energy sector has flagged far behind the broader market for the one and three-year periods ended April 6, 2008. Growth investors haven’t just ignored energy, they are actively avoiding it.

That has consequences for executives and boards of E&P and oilfield services companies. Value investors are driving the narrative and handing a new set of preferences to public companies, some of them well-founded, others not.

Implications for E&P investors

Grow is a four-letter word (focus on returns). Value investors are telling E&P management teams that they want them to focus on returns and not growth for its own sake by limiting capital spending to within cash flow. Among a few others, fast-growing PDC Energy, Inc. (NYSE: PDCE) was quick to point out in their recent earnings calls that they expect to achieve free cash flow positive status this year. In the supply-driven oil and natural gas markets, investors are wary of E&Ps looking to tap the financial markets with dilutive equity offerings without a strong use of proceeds.

Valuation disconnects. The dominance of value investors in energy sector stocks means equity valuations and multiples have suffered. Since oil and gas is a natural resource industry, the PV-10 value of a company’s proved reserves or oil-in-the-ground serves as an anchor of intrinsic value. Several companies having quality assets and strong management find their total enterprise value is less than the PV-10 value of their proved reserves.

For example, on April 6, 2018 Range Resources Corporation’s common equity closed at $13.97 per share making its market capitalization $3.42 billion and enterprise value $7.81 billion, as compared to its 2017 year-end 2017 pretax PV-10 value of proved reserves of $8.1 billion. If you believe financial markets are efficient, investors are implicitly saying that RRC, which posted a 30% production growth rate in 2017, is worth less than the intrinsic value of its proved reserves assets.

Despite delivering a top-tier production growth performance and communicating a new five-year plan demonstrating free cash flow escape velocity this year, there simply were not enough growth investors listening to make a difference. RRC’s valuation disconnect may have attracted value investors, but without growth investors validating the increase in intrinsic value, the stock remains stagnant.

This is what it looks like when a tree falls in the forest and there’s no one to hear it.

Activating the oil and gas industry. When it becomes less expensive to buy barrels on Wall Street than to drill for it, activist investors take notice. Word on the street is that there are powerful forces working to consolidate E&Ps into larger companies with more expansive acreage positions over which to achieve and extend economies of scale in buying services for reducing costs and boosting long-term returns.

Potential consolidators and acquisition targets have been identified already by hedge funds seeking to exploit valuation disconnects, cobble smaller companies into larger ones on the cheap and reap the rewards once commodity prices turn around. For example, Elliot Management, a well-known activist investor, has apparently decided to back Sundance Energy (Nasdaq: SNDE) as a vehicle to consolidate U.S. shale assets. We have heard of other similar conversations going on between investors and management teams, and it will be interesting to see how buyers and sellers sort themselves out.

Consolidation. The most recent, and perhaps most significant sign that the industry consolidation is already underway is Concho Resource’s (NYSE: CXO) acquisition of RSP Permian (NYSE: RSPP) in an all-stock transaction between two Permian Basin pure plays valued at $9.5 billion, inclusive of $1.5 billion in net debt. Concho chief Tim Leach arguably knows more about the Permian Basin than any industry executive and his company’s move to buy RSPP is indicative that valuations are ripe for the picking.

Fragile fundamentals return. The global crude oil markets have been supply-driven over the past four years, and now some sense of rationality has begun to take root, at least with regard to WTI. The chart below plots weekly U.S. crude oil inventories with the spot price of WTI. Since the beginning of 2017, these data series have exhibited a strong negative correlation of .7215, which makes intuitive sense. As inventories have increased (more supply), the price has declined 72% of the time and vice-versa.

The relationship has not always been this strong, and in fact, since the beginning of 2001, it is a weak .3255. Clearly, investors are looking at crude stocks to tell them when the supply overhang will burn itself off and create the need to send industry a higher price signal to stand-up more rigs. Growth investors will have to wait a little longer before oil prices return to steady upward trend.

Sell side stress. Investment banks, both large and boutique, that focus on the oil and gas industry have been hit and some hit very hard. For example, as we reported previously, the energy investment boutique Iberia Capital Partners pulled the plug on energy trading and research late last year, and word on the street is that commissions at other energy specialists are down 25-30%.

Many larger banks are consolidating oil and gas equity research into cyclicals and materials, as trading declines, commissions drop, and investors shun energy IPOs. That means fewer skilled specialists communicating to the institutional investor community, and it also means that the institutional investment community has lumped E&P into a box of cyclical industries, none of which have growth potential (true or not). Investors will need to do their own research to uncover the best ideas.

Our read of the tea leaves is that although oil prices have improved and leading E&P operators are growing production and value, we haven’t seen the market reward them for it because growth investors are sitting on the sidelines for now. Once generalists and growth investors take notice, however, we would expect valuation gaps to be erased quickly.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Our firm has done business with PDC Energy, Inc.

 

 

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