Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
The Once and Future Shakeup in Oil and Gas
Although there are stocks and entire sectors making new highs in this somewhat surreal market environment, one area that has not recovered quickly is the oil and gas sector. To be fair, energy was under a great deal of pressure even before the COVID-19 crisis. That pressure was increased by the oil price war in March following the initially failed OPEC+ agreement that would have allowed production cuts to expire. Disaster in that regard was eventually averted, but the market remained heavily oversupplied. Further, the market generally understands that OPEC+ discipline is artificially supporting pricing at current levels. Although demand has returned, it is nowhere near pre-crisis levels.
One of the offshoots of the collapse in pricing was greater distress in companies with balance sheets that were stretched before the crisis hit. In many cases, corporate governance was lax and contributed to the enabling of such destruction of capital. Many of these companies are out of compliance with debt covenants, and you often see the words “strategic alternatives” in recent press releases. On the other hand, those that maintained capital discipline and did not sacrifice their balance sheets for growth are pricing senior unsecured long-term debt between four and five percent. Is it any wonder, then, that a key theme we have seen accelerate in the past several weeks is that of the no-premium M&A deal?
This round of consolidation is much needed. A merger can serve to effectively recapitalize a company with good assets but a challenged capital structure. It can significantly reduce G&A costs and lower corporate overhead, which serves to increase scale and enhance returns. Fundamentally, there needs to be concession on the part of the industry that oil and gas is structurally no longer a growth business. The wave of renewables, although not yet economically competitive, will ultimately innovate its way toward that end.
This is not to say that we can substantially eliminate or even reduce hydrocarbon demand in the near-term, but the push toward “greener” solutions is a trend that appears to be here to stay. In the meantime, the cyclical nature of the business and its vulnerability to boom-bust cycles is creating a Darwinian “survival of the fittest” dynamic. Those who have not exercised capital discipline may be forced to accept a smaller piece of a company that has favored returns over growth. While we may see a cyclical bounce in the near-term, there is clearly ample capacity to turn the production spigot back on, both here in the United States and within OPEC.
Ultimately, the industry may be forced to accept slower growth and a more utility-like business model – meaning that the investment community will look to the industry for stable returns over a cycle and return of capital to shareholders in the form of dividends or buying back stock. It is different than utilities in the sense that the cyclical nature of the business makes it so balance sheets cannot carry as much debt as a traditional utility. The good news is that more of those returns accrue to the equity holders. Historically in commodity businesses, this sort of returns-over-growth thinking goes right out the window when pricing recovers. However, it is hard to see a meaningful path to price recovery of $55+ in the near- to medium-term.
Overall, there have been simply too many companies chasing growth for the sake of growth while turning a blind eye to returns. Many never walked the talk of capital discipline. As a direct result of this, energy has gone from over 20 percent of the S&P 500 to less than three percent over the past several years. Perhaps the no-premium merger ushers in a new paradigm for the oil and gas industry that may restore its relevance in the capital markets. It will be a tough pill for some management teams to swallow, but, ultimately, consolidation should be supportive of pricing as more capital-disciplined companies slow the rate of overall production growth.
Chief Executive Officer