Who Will Survive Oil's Crash?

The Energy Report |

The crash in oil prices and the continued depression in gas prices have exploration and production companies and their services providers hunkered down, cutting capital expenditures and trying to bring spending into line with income, says Wunderlich Securities Analyst Jason Wangler. The likely survivors have similar traits, and in this interview with The Energy Report, Wangler shares their secrets, and names companies he expects will have an especially bright future.

The Energy Report: Jason, last summer oil was more than $100/barrel ($100/bbl) and most analysts were forecasting long-term stability in the $80+/bbl range. What tipped the oil price into freefall in July?

Jason Wangler: For the last five to seven years, Saudi Arabia has effectively filled the hole between supply and demand. When the oil price was high, producers were ramping up oil production, so Saudi Arabia's market share declined. In July and the months that have followed, Saudi Arabia, a low-cost producer, decided that rather than just continue to fill this hole, which was continually becoming less important, it would make a stand and show the world that it can produce oil at a lower cost than other countries. We are starting to feel the effects of what that means for oil prices.

TER: Saudi Arabia had that much influence in the market? It could just kick out the props and let it fall?

JW: The world market has about 93 million barrels per day (93 MMbbl/d) of production. Saudi Arabia produces about 10 MMbbl/d of that. We—meaning the U.S.—are also at about 10 MMbbl/d now, and Russia is 8–9 MMbbl/d. Those are the three biggest players in the game. But Saudi Arabia is different from the U.S. or Russia in that it has the ability to very quickly speed up or slow down production as it sees fit.

For the last five years or so, the Saudis sped up or slowed down production according to world demand. And as the U.S. continued to grow production almost 1 million barrels/day in each of the last couple of years, the Saudis were seeing lower market share. And finally, the Saudis decided they didn't want to continue to be a less important player. They wanted to show the world that they still have a significant control over prices. And they do. This is an exporting country. It can control how much to put into the market.

TER: Oil prices continue falling. Are you seeing any signs of a slowdown yet?

JW: In terms of the price? I don't think any producer can really sustain at $50/bbl oil. But the price keeps falling, so in the near term there's some irrationality in the market. I'm hopeful it starts to slow down, because nobody's making money at these levels.

TER: What's your forecast for oil this year?

JW: Right now, for the full year, we're forecasting oil at about $70/bbl. We think the price will start to correct itself—the question is how quickly—and get back to a level that is rational from an economic perspective, whether in the U.S. or internationally. We're using $70/bbl as the price because in the U.S. everybody is cutting capital expenditures (capex) dramatically. You'll see that across the globe as well. People try to rectify cash inflows and cash outflows, and that's going to take some time to wash through the system. But soon you'll start to see hypergrowth in the U.S. In other places growth will slow down because of the lack of investment.

TER: Natural gas has struggled to remain above $3/thousand cubic feet ($3/Mcf), and it's still under pressure. What is your forecast for gas this year?

JW: We haven't been bullish on gas for the better part of the last five years. We have so much supply in the U.S. that you could tell me a number and probably back into how much is going to be produced. For a full year we're forecasting prices in the $4/Mcf range, which I don't think is too crazy. It's finally starting to get cold across the U.S., so we'll see if weather impacts the price. Last year, we very briefly touched $6/Mcf in the February–March timeframe.

But outside of short-term weather impacts, we don't see any huge demand drivers increasing the health of natural gas prices. Even if you do get those drivers, we believe there's a lot of supply out there, and producers will be happy to put gas to work at any certain price.

TER: If there is a chill in the weather coming up, is the storage high enough now to keep prices in check this winter?

JW: We're pretty close to the five-year average, so we have plenty of gas in storage, but we don't have more or less than in the last few years.

Assuming the weather is cold, you should see some support in natural gas pricing because we will draw down the inventory. For the most part, we believe the biggest driver of natural gas pricing is short term: weather. From a longer-term perspective, there's not anything we see that will be able to dwarf the supply that we could potentially turn on in the next few years if we needed to, because of all the great gas plays that we have.

TER: What effect do low gas prices in North America have on the prospects for liquefied natural gas (LNG) plants that have been proposed?

JW: The lower the price of gas in the U.S., the better the chances that those plants become economic. The headwind has not been low natural gas prices. That's been the big tailwind for the idea of LNG. The problem has been more political or regulatory, in that these are very large, very capital-intensive projects. You have to get a lot of permits to go forward, and they take a long time to build.

We're going to see some incremental LNG work come on line later this year and into 2016. That will be very interesting because there is an arbitrage here. We have low natural gas prices, at $3–4/Mcf. You go over to Asia, or even to Europe, and you're talking about $7/Mcf, and sometimes as high as $12–13/Mcf. There is a very simple arbitrage if you can get it fully up and running. The issue is more in terms of how slow it's been to develop due to the regulatory hurdles. Right now is as good a time as any to take advantage of the arbitrage, given how low pricing is in the U.S.

TER: Are both oil and gas responding to the same drivers?

JW: Yes and no. They're both in an oversupplied market right now, but the reason for the oversupply is different. Natural gas is a domestic product. It's wholly contained within the U.S., and we have a lot more supply than demand. So we've seen depressed natural gas prices for the last five to six years now.

Oil has done very well for a long time. It's more of a world commodity, though we can't yet export it from the U.S. officially. The price is a nationally driven number, but it is a world commodity. The issue has been oversupply, not just in the U.S. shale plays, which are only about 4–5 MMbbl/d of the 93 MMbbl/d produced worldwide, but from the effects of other producers deciding that they want to fight for market share as well. The oversupply of oil is market share-driven.

TER: How are the exploration and production (E&P) companies responding?

JW: The only thing they can do is hunker down. Across the board they are cutting capex as fast as they can, trying to right-size spending versus income. At $90–100/bbl oil they were getting better cash flows, and the capital markets were wide open for them. Nowadays, the capital markets are relatively closed, and the E&Ps are getting half as much cash flow for every barrel they're producing. So they're pulling back activity as quickly as possible.

I think you'll see the rig count get hammered the next few months, probably going from the 1,900-rig range a few weeks ago down to at most 1,500 rigs—and maybe lower—very quickly. E&Ps are spending less on growth as they focus more on surviving and keeping a decent balance sheet.

TER: Does the strong U.S. dollar have an effect on the upstream oil and gas companies?

JW: It doesn't help. A weaker dollar makes it easier for other countries to buy oil. The stronger dollar makes it more expensive, in foreign currency, to buy oil. Alongside all of this discussion about Saudi Arabia and oversupply, the fact that the U.S. dollar continues to strengthen makes those barrels more expensive in foreign currencies, prompting buyers to wait and see if they can pay less. The strengthening dollar has been another headwind for oil prices.

TER: Tell me about some of your favorite upstream companies, whether they're E&P or oil field services. How are they responding to the oil price downturn?

JW: As I said, across the board it's pretty much the same story. These companies can cut spending, whether that's operational or capital, to keep focused on the balance sheet rather than on the income statement or on growth. And in a cyclical business, during the down part of the cycle, some companies will survive to see better days, because at some point the cycle will turn. We don't know when, so right now it's simply a matter of battening down the hatches and doing the best they can in a bad market, waiting for a better day.

TER: What are some of your favorites?

JW: Some of my favorites are Earthstone Energy Inc. (ESTE) , Gulfport Energy Corp. (GPOR) , Gastar Exploration Ltd. (GST) and Chesapeake Energy Corp. ($CHK) on the E&P side. On the oil field services side, I really like Seventy Seven Energy Inc. (SSE) , Superior Drilling Products Inc. and Natural Gas Services Group Inc. (NGS) .

A lot of these companies share similar traits. I like having a decent gas content because with most commodities depressed, having diversity through two commodities is a good strategy. I don't know which commodity is going to do better going forward, but having the ability to deploy capital to either one is a strong position.

Having a great balance sheet right now is about as important as anything, given the fact that companies have to batten down the hatches and try to survive. Having too much debt or having the issue of not being able to meet commitments, whether financial or operational, is a death knell. Gulfport Energy, Gastar Exploration, Earthstone Energy and Chesapeake Energy all have that ability. From the services side, it's the same thing. It's about being able to maintain your current position, generate some cash and wait for a better day, and that's what I think those three services companies can do.

TER: Why did you initiate coverage of Earthstone Energy in December 2014?

JW: Earthstone just finished a reverse merger with a private company called Oak Valley Resources LLC. I've known the management at Oak Valley for quite a few years. They used to run a company called GeoResources Inc., which was bought a few years ago by Halcón Resources Corp. (HK:NASDAQ) for about $1 billion ($1B). The management team made these kinds of deals three or four times. The team has been very successful; members know how to not only build an oil and gas company, but also how to create the endgame of monetizing it. I think they have a great opportunity to do it again at Earthstone. The last time the management team entered into a very successful merger was 2008–2009, when most people were in a bad spot.

I initiated on Earthstone when the Oak Valley deal closed in December. The company has $100 million ($100M) in cash and no debt on the books. While many companies have a lot of debt and have to focus on just staying alive, Earthstone can be opportunistic and maybe go out there and grow through acquisitions.

TER: That combination with Oak Valley was interesting. What was the rationale behind that combination?

JW: Earthstone Energy, being a small, nonoperated Bakken shale player, was a public entity. Oak Valley was a private entity that wanted at some point to become public again, so Earthstone Energy brought to the table a public vehicle that was already trading on the markets, as well as some Bakken exposure, which the Oak Valley guys have known well. Oak Valley brought some capital—that $100M in cash—and the management team.

TER: That sounds good for the company. How did the stakeholders in each company benefit?

JW: From the Oak Valley perspective, it's becoming public and will have an ability to monetize a position, whether today or in the future, through selling shares or something of that nature. Also, it allows Oak Valley to be in the public markets to raise money. For Earthstone Energy, the benefit is a lot more scale. It has only about 2M shares outstanding; it's a very sleepy Bakken company. Now it has the Bakken asset and some pretty nice Eagle Ford shale assets as well, brought over from Oak Valley, plus a very good management team.

TER: Will oil prices drive more consolidation in the E&P space?

JW: I think there will be a feeling-out period for the next few months, during which we probably won't see a lot of deals happen. The bid and ask are very far apart: The people selling the assets want $90/bbl and the people buying them want to pay $30–40/bbl. It's going to take time to get those two numbers to a rational or meaningful gap, so that people can actually sit down at a table and have a discussion about a transaction.

That being said, I think we are going to see a lot of consolidation and a lot of asset transactions over the coming year. I don't think it will happen much in Q1/15, but after we get out a few months, hopefully we will finally know what oil and gas pricing environment we're in. Then I think we will see a rash of transactions, for both assets and companies.

TER: Can you identify some companies that are ripe for this?

JW: The buyers will be larger companies that have great balance sheets—that have the ability to pay for assets that are probably not priced as highly as they would have been otherwise. I think Chesapeake Energy will be very acquisitive, given its recent sales and great balance sheet. Some of the companies in the Permian Basin, like Diamondback Energy Inc. (FANG) or even Pioneer Natural Resources Co. ($PXD), will look to pick off assets at good prices, and they have the balance sheets to do it.

From a sales perspective, I think they're all for sale right now. The price is probably too high. There could be some forced selling in some weaker names, but to be honest I'm not sure who's going to be able to pull the trigger, or who wants to.

TER: Are oil field services companies responding differently to the oil price decline than E&Ps?

JW: Oil field services company revenues are predicated on what the E&Ps do, so they're the second derivative. First, you have oil prices coming down. Then you have E&Ps cutting spending very hard. There is some lag time for effects to flow through the system, but then the oil field services companies are going to get hit very hard as well. That's probably going to happen in Q1/15 and Q2/15.

We haven't seen the rig count drop off dramatically yet, but it has fallen the last three weeks. I expect to see a few hundred rigs coming off in the relative near term. That's going to be very difficult for the services companies. They are doing a lot of the same things their customers are doing: cutting staff and spending to the bone just trying to stay alive.

TER: Has Seventy Seven Energy shown the effects of this?

JW: Not yet. None of the service companies have shown impacts, from a reported numbers standpoint. In Q4/14, these companies were working through the 2014 capex budgets of the E&Ps, so across the board I think they did okay. Going forward though, starting in Q1/15, they're all going to get hit.

Seventy Seven Energy has contracts to do a lot of Chesapeake Energy's work, so about 80% of the company's revenues are from Chesapeake Energy. Seventy Seven has one client that it has focused on a little bit more than most, and I think that's going to serve Seventy Seven Energy very well, given that Chesapeake Energy's financials are so great that it shouldn't have to cut spending as much as the industry as a whole.

TER: Could that reliance on Chesapeake Energy raise a red flag?

JW: Seventy Seven was a part of Chesapeake at this time last year. It was spun off and given contracts to continue to provide services. It is focused on getting other third-party work. It has already grown: It was at 92% Chesapeake Energy work in Q1/14. Seventy Seven is focused on diversifying.

The percentage of work with Chesapeake is a double-edged sword. It's great to have all this work from one client, but if that client does something different, Seventy Seven could be adversely affected. In this market, I think it is actually a benefit because Chesapeake Energy's going to do more work than most in the space, and that's going to provide Seventy Seven with more work than most service companies in the space.

TER: You slashed your price target for Triangle Petroleum Corporation ($TPO:CA)  (TPLM) from $13/share to $6/share. Are you still positive on Triangle?

JW: We slashed a lot of our price targets because we moved our oil deck so aggressively from the $90–95/bbl level to $70/bbl. All of our targets came down pretty hard, Triangle Petroleum being no exception.

I still like Triangle's story, as far as having the services component of its business self-contained, because it also has its midstream business. And while the Bakken is not a great place to be right now, from weather or from a pricing standpoint, I think Triangle's ability to maintain a couple of different assets—and that being investments in companies—is going to serve it well for a longer-term investor looking at full returns. Its separate businesses are worth more than the stock is today, and I think people are missing that aspect of it.

TER: Your 2015 earnings per share estimate for Gastar Exploration went from $0.80/share to $0.22/share. Is this company going to have adequate revenue to justify the fundraising it did at the beginning of the downturn?

JW: The fundraising is already done, so that ship has sailed. At the same time, as I have said, our earnings estimates across the board changed pretty dramatically because of the lower commodity deck.

I think that, overall, Gastar Exploration will do well. In fact, I think the money raised gives Gastar a lot of liquidity, at just the right time, with the market closed up. The company's going to struggle along with everyone else, but it now has a good balance sheet to get to the other side. And it has a lot of nice assets. The assets are all held by production, so the company does not have any capital commitments to worry about.

TER: How did Gastar do that fundraising? What was the mechanism?

JW: It was a straight common equity deal, as many companies have done in the past. Gastar just happened to do it at the end of the window so to speak. In fact, it paid down quite a bit of debt with the funds.

TER: In closing, what's your advice for an oil and gas investor in these times?

JW: If I'm in the chair, I am looking to nibble at high-quality names. Probably not trying to take full positions in anything, because it seems that every day any stock could be down 10%—not necessarily because the company did something wrong, but because the market is just not good right now. Prices are very, very depressed.

These price levels don't make sense from a long-term perspective, and I think there is a lot of value in these names. If you can hold your nose and stick with some good, high-quality names, there are a lot of big returns to be made over the next 12, 24, maybe 36 months.

TER: Thank you.

Jason Wangler has over five years of equity research experience focused on the E&P and oilfield services sectors. Wangler previously worked at SunTrust Robinson Humphrey and Dahlman Rose & Co. before moving to Wunderlich Securities. He also previously worked at Netherland, Sewell & Associates Inc. as a petroleum analyst. He received his Master of Business Administration from the University of Houston, where he was also named the 2007 Finance Student of the Year. He received his Bachelor of Science degree in Business Administration with a focus on finance from the University of Nevada, where he was named the 2003 Silver Scholar award winner for the College of Business Administration. In 2010 he was highlighted as a "Best on the Street" analyst by The Wall Street Journal and he has been a guest on CNBC.

Source: Tom Armistead of The Energy Report (1/15/15)

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Companies

Symbol Name Price Change % Volume
GST Gastar Exploration Inc 1.28 0.00 0.00 1,087,719
ESTE Earthstone Energy Inc. 14.00 0.44 3.24 57,013
TPLM Triangle Petroleum Corporation (DE) 0.40 0.03 8.84 6,218,594
GPOR Gulfport Energy Corporation 29.36 0.57 1.98 2,242,264
SSE Seventy Seven Energy Inc n/a n/a n/a 0
FANG Diamondback Energy Inc. 107.26 1.87 1.77 778,854
PXD Pioneer Natural Resources Company 187.01 1.23 0.66 1,420,897
CHK Chesapeake Energy Corporation 7.60 0.02 0.26 72,009,796

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