drilling down

[Note: I have a piece up on CNBC.com today about RadioShack’s impending bankruptcy. Click here if you’d like to check it out.]

Judging by the last few days of trading, it looks like oil prices might (emphasis on might) have found a bottom. That would be bad news for big oil consumers like airlines–not to mention ordinary Americans, who’ve been enjoying a de facto tax break at the pump–but it would come as a major relief to anyone hoping for our incredible domestic energy renaissance to continue.

Last week I attended a one-day energy conference in Denver. Sponsored by a West Coast brokerage, 25 institutional money managers and I visited six E&P (exploration and production) companies at their downtown headquarters. Four of the firms drill in the Niobrara, which is the basin underneath Denver that extends to the Wyoming and Nebraska borders. The fifth drills in the Bakken, which is the relatively new basin underneath North Dakota; and the sixth drills in the Texas Permian basin, the largest oil field in the lower 48 states.

The mood in those offices didn’t quite give me flashbacks to my early days in the investment business, when I watched the entire economy of Houston implode during the Great Texas Oil Bust of the mid-1980s, but I definitely experienced a few minor bouts of deja vu.

All six companies admitted that the recent decline in oil prices to $50 from over $100 last August was a big surprise. Just like in the 80s in Houston, nobody in the oil patch saw such a steep drop coming, especially so quickly. Most of the six companies were smart (or lucky) enough to “hedge” a large part of their 2015 production and some of their 2016 production at prices closer to $100 than $50, but all of them have already enacted cutbacks in their drilling budgets, and do not plan to spend significantly more this year or next on their new, lowered cash flow outlooks.  Every executive we spoke with said the big loser in a long-term lower-price environment would be oil service companies, as E&P firms are already demanding, and getting, lower prices for drilling rigs, as well as 25 percent or greater price cuts for supplies like frac sand and drilling mud and services like downhole engineering work and pressure pumping.

So what does all this mean for investors? Even if the recent rally in prices holds, oil services companies—especially those with hefty debt loads—will probably continue to struggle. Prices for their services will remain depressed, and if their debt obligations are onerous, lower revenues and cash flows might crimp their ability to make interest and/or principal payments. That could easily lead to a rash of bankruptcies in the sector. Exploration and production companies, on the other hand, should come through the downturn in better shape and bounce back more rapidly.  Producing oil and gas, even at lower prices, is still a profitable activity. The biggest expense for these operators is the cost of drilling new wells, many of which turn out to be dry. Then again, if oil prices top out after the recent uptick or head lower again, we might see a few heavily indebted exploration companies file for bankruptcy, as well, because interest payments do not go down when cash flows do.

Lastly, this week’s rally notwithstanding, I think many energy companies and energy investors became just as one-sidedly bearish in recent weeks as they were bullish before the downturn. That kind of groupthink can always signal opportunity. Most energy stocks are now closer to 52-week lows than 52-week highs, so if oil prices continue to rally, we could see major moves in these stocks–20, 30, or even 40 percent in a matter of weeks. For that reason I would encourage investors to bring their weighting in energy close to or even above the groups existing 10 percent weight inside the S&P 500.


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