Small- and mid-sized U.S. oil companies sold $10.8 billion of new equity in the first quarter of 2015, according to the Financial Times – a new record for the industry.
Yet, given the current profit outlook for upstream firms, I strongly suggest avoiding the exploration and production industry, including oil production master limited partnerships (MLPs), for the foreseeable future.
Now, that may be a surprising reaction to the quarter’s record issue volume.
After all, such movements typically mean that investors are enthusiastic about the industry. And while they’re sometimes wrong – the “contrarian” strategy rests on the theory that investors are often wrong – it’s a bit cynical to issue strong predictions based on investors’ stupidity.
In this case, though, the circumstances should scare anyone from joining the record inflow.
A Quick Solution
Until last July, smaller U.S. oil companies had been expanding at a rapid rate. In fact, 2014’s increase was the biggest since 1970.
That expansion had been financed largely with debt, as interest rates were low, debt was generally available, and banks were eager to lend. Unfortunately, that eagerness was based on supposedly “conservative” forecasts for the price of oil – somewhere in the $85 range.
It didn’t take long for oil prices to fall below small oil’s worst-case scenarios, and many projects became unprofitable even on a running basis without amortizing capital expenses. You see, U.S. oil is expensive relative to Middle East oil, so the majority of new ventures – “fracking” projects, deep sea productions, and geologically difficult formations alike – have higher costs than most major oilfields.
Yet, this wasn’t an immediate problem, at least as far as small oil’s income statements were concerned. Many companies had hedged their sales prices in the forward market, so they could remain profitable for a few quarters.
They did, however, need to reduce their debt and build liquidity to complete ongoing projects and keep operating in an environment that had suddenly become hostile. The obvious solution was a quick share issue.
A Horde of Zombies
Based on the financial data available, the companies looked very cheap – trading at single-digit multiples of historic earnings. By issuing new shares, they could stock up on liquidity, complete the most promising drilling programs, and repay the most pressing portions of their debt.
But, for investors, this flood of equity capital into the industry is bad news.
You see, the most likely way for oil prices to recover to a level at which U.S. high-cost operations are profitable is for capacity to leave the small oil industry. In that case, new output from U.S. fields would quickly slacken and indeed reverse, as some of the fracked production, in particular, has a field life of just 18 to 24 months.
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However, with the newly recapitalized zombie competitors remaining in the sector, overcapacity will persist and U.S. oil output will increase, preventing a recovery in prices.
Therefore, investors should avoid most production MLPs.
Linn Energy (LINE), for instance, is now trading at one-third of last year’s price, and its current monthly dividend equates to $1.25 per annum, a whopping 10.9% yield at today’s share price. The company hedges oil sale prices, so even though it has lost money in each of the last three years, it’s trading at just 82% of book value. Nevertheless, I’d regard this stock as a high-risk proposition at best, with a dividend cut in the near future very likely.
Even a safer midstream company such as Enterprise Products Partners L.P. (EPD), which provides pipeline, processing, and marketing services to the natural gas industry, is hardly worth a look. EPD has a more modest yield of 4.5%, but its dividend is barely covered by earnings, and it’s trading at 22x projected 2016 earnings.
Thus, I come back again to the refiners. If energy prices are due to stay low for a prolonged period, then they’ll do well. Energy usage will be high, and refinery capacity will be constrained, since no U.S. refineries have been completed since 1979.
Northern Tier Energy LP (NTI), for example, yields 7.8% based on the trailing four quarters of dividends, and trades at just 7.7x projected 2016 earnings. As explained in previous articles, dividends on NTI will fluctuate, because refinery earnings fluctuate… but, on average, you should do pretty well.