The Future of Energy Stocks

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Published by Jake Bleicher

The price of oil has been cut in half since June when West Texas Intermediate (WTI) was selling at $107 per barrel. The excitement has provided ample fodder for industry analysts and media journalists to speculate about future prices. Some of the leading soothsayers have developed intricate models in order to predict exactly when prices will recover. In my opinion, basing an investment decision on the forecasted prices of oil leaves too much uncertainty in the equation. I prefer to focus on concrete fundamentals that I can easily observe today, such as balance sheet strength and operating costs. Basing an investment decision on these known factors allows me to isolate the future trajectory of oil prices as a known unknown. I know for a fact that I do not know what the price of oil is going to be in six months so I can model it very conservatively. I can take a company which I know has a strong balance sheet and a competitive operating cost profile; then model a scenario in which oil prices decline further and stay there for an extended period of time. Modeling a worst case scenario for the unknown reduces the downside exposure, and thus my sure to be incorrect forecast will surprise to the upside.

Perhaps the most important aspect of an energy company right now is the strength of its balance sheet. Drilling for oil is a very capital intensive business. When the price of oil was above $100, the returns were so favorable that it made sense to borrow in order to grow faster. It was not uncommon for small companies to grow their sales by more than 50% as production accelerated. However, in the current environment drilling has ground to a halt. Companies that have stretched their balance sheets to fund rapid production growth are burdened by high interest payments at a time when cash coming in the door has slowed to a trickle. The ultimate question is what companies will survive a prolonged downturn and the answer is the ones with plenty of cash and a minimal amount of debt. The best companies with plenty of cash will capitalize on the weakness by purchasing distressed assets at a very low cost.

After identifying companies with strong balance sheets I look for those with below average operating costs. In the oil & gas world, costs are observed on a per barrel basis. Essentially, I want to know which company can get a barrel of oil from underground to market for the lowest cost. Another way of looking at this is; which company can drill profitably in a low priced oil environment? Multiple factors impact the cost of drilling but geographical location is a big driver. Drilling for oil in Colorado or North Dakota often requires the operator to drill deeper than if they were operating in Texas or Oklahoma. Drilling deeper requires more equipment and thus added costs. Location also impacts the cost of transporting the commodity to the buyer. It costs approximately $9 per barrel to send oil via rail from the Bakken to the refiners along the Gulf Coast. Without getting into too many details, it is clear that a company operating in Texas can continue drilling profitably much longer than a company in North Dakota. Of course this cannot be applied in every scenario, some companies may benefit from scale or proprietary technology that more than compensates for the higher transportation and drilling expenses.

Again, the strength of the balance sheet is first and foremost. A company drilling in Oklahoma with the most proprietary technology is no bargain if their debt is unmanageable. Before investing there are many other factors to consider, but these fundamental metrics provide a much more defensible rationale for investment than a prediction of future oil prices. Trying to forecast the future price of a volatile commodity is a waste of time. Too many of the factors that influence the price of oil are out of your control. For instance, no one knows what the outcome of OPEC’s next meeting will be or what Chinese demand will be in 2015. Most of the articles I read focus on these known unknowns and digesting all of the speculation results in decision paralysis. Focusing on known variables is the best way to make a sound investment and the rest amounts to nothing more than frivolous noise.

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