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M&A The Only Survival Strategy For The Oil Sector Now

M&A The Only Survival Strategy For The Oil Sector Now

History dictates that flat oil price curves are rare events and usually signal a pivot point in future pricing and economic activity. Today’s curve can’t get much flatter, as the December 2015 futures contract is within just $2-3 of the same month in 2017. There is no doubt that part of the reason that the curve is flat is tied to significant producer hedging, as financial institutions that usually take the other side of a trade are currently on the sidelines, tied to a wall of negative sentiment generated by the media and others whom who are banking on oil declines to boost consumer sentiment. This morning’s consumer spending stats were essentially flat and the excuses based on the weather were exposed as plain propaganda once again.

The Atlanta Fed took swift action, prudently cutting second quarter GDP estimates to recessionary levels at 0.70%. This runs counter to expectations portrayed by the “perception is reality” Fed, which wants to give the illusion that rates are about to go up. But the threat of rising interest rates and bets on a rising dollar do affect future oil price sentiment and may be partly to blame for why the curve is so flat. One would think that the expectation of rising economic growth would help prices but in the centrally controlled banking world that we now live in, it’s just the opposite. Related: U.S. Could Go All Out On Offshore Exploration

As stated here repeatedly, asset prices are driven by what investors expect the Fed to do vs. real world fundamentals and since expectations are for rising rates and higher dollar, I believe future price expectations for oil are understated, given what is going on in the physical market. The Iran overhang may also be at work on the supply side too as we move into 2016, although to a lesser extent. But overall until expectations shift towards the likelihood that the Fed will turn to QE4, it appears we are probably stuck with $60-$70 oil. As I have stated that will come in due time.

All the propaganda and excuses are slowly getting exposed as the lies they are, as is sluggish corporate EPS growth despite all the stock buyback gimmicks. The poor economic stats can’t be hidden forever. Be that as it may, that doesn’t guarantee QE4 will temporarily boost growth again and with a bubble brewing in equities, housing, art, you name it (except energy). This is a precarious time overall, as equity indices appear to be topping out alongside the oil price curve. My call is that oil in the short-term tops out at around $70 as I believe a crisis has to occur before calls for QE4 grow loud enough to change expectations. Related: Who Is The Biggest Player In Energy?

So what is the most likely outcome of a prolonged period of prices stuck in the $60-$70 range, especially as the dual threats of more supply and waning economic growth loom over any change in QE sentiment? This would likely translate into very slow, if any, volume growth in the E&P space going into 2016 which isn’t supportive of the current 50% premium valuations that exist in the sector. Both private equity and the Fed’s easy monetary policy are to blame for overvalued assets in the E&P sector. In the second half of 2015, the reality that traditional growth can’t support current valuations will set in as credit redeterminations occur in the fall and hedges roll off. This will lead to further asset sales, as bloated stock valuations will likely reflect soon.

The Williams Companies’ (WMB) purchase of Williams Partners LP (WPZ) only confirms the theory of a prolonged period of low volume growth in energy, as do many other transactions in the mid- stream space. Unlike the last downturn, the mid-stream is highly dependent on volume growth, as fee-based revenues now dominate. This reality has not sunk in with E&P companies yet, as M&A activity remains tepid. Related: 3 Ways Oil Companies Can Survive Low Prices

It appears then that it will accelerate, as many E&P companies continue to spend over their free cash flow to survive the rapid decline rates in their shale wells. Thus, many E&P companies will discover that neither volume nor price increases will be path to growth, but instead M&A will be the only path to do so, at least in the short term. The more mature assets will find their way into MLP structures which stand to benefit the most from these realities, in my view.

By 2016, I expect the public and private E&P space will shrink considerably, as scale will be the only way to survive, never mind grow.

By Leonard Brecken of Oilprice.com

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