There is a war on oil in America and oil executives better wake up to it. At every turn the media is hyping the negatives and dismissing the positive facts on where oil prices are going. And it appears Wall Street is happy to follow.
I’m not defending the fact that oil prices are tied to inaccurate EIA figures on production, but since it seems Wall Street is driven by “perception” in the media vs. hard researched facts, we are where we are.
I bring this up because I live in an East Coast, Wall Street-dominated town and can’t help but drive by a Tesla car almost every. I have nothing against electric cars or Tesla, as I believe they will be needed in the years to come as oil becomes scarcer. But it lends insight into the subconscious of fund managers and their ideologies. And this seems to be what is driving many of their investment decisions these days, whether they realize it or not.
In the past, I have made parallels between the shale business model and Netflix (NFLX) both of which burn huge amounts of cash, and both seem incapable of generating a dollar of free cash flow over a sustained period of time. Pioneer Resources (PXD), the premier independent share producer in 2015, is expected to burn $600 million cash while generating $1.6 billion in operating cash flow but requiring $2.2 billion in capex to sustain production and grow it by 20 percent.
With hedges rolling off soon, and continuing into 2016, I doubt cash flow will grow with production. The addition of 2 rigs or so per month over the next several quarters will only fuel the already negative sentiment driving shares and oil prices lower as well.
I say this because that is what the current sentiment dictates. The data on both inventory and demand belie the bearish sentiment, but Wall Street believes the oil market is soft right now. And what Wall Street believes is what ultimately matters since futures contracts are owned more (24 times more to be exact, the highest in recorded history) by the investment community than by oil companies. Related: Venezuela At A Crossroads
So it’s not true that supply and demand dictate price, rather prices overwhelmingly depend on what Wall Street thinks they should be. As I have said in the past, asset prices are set more by the whims of central bankers than by the fundamentals.
The hypocrisy comes into play as Wall Street shuns the same model in one sector while cheering and driving valuations to the moon in another. I don’t know how starker a contrast you can have when the E&P sector, as measured by the XOP, is near a 52 week low, down 50 percent off its high, while the technology laden Nasdaq Composite trades over 5000, near an all-time high. An even sharper contrast can be found when looking at Tesla (TSLA) making 52 week highs daily. Related: EIA Data Still Diverging From Reality
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The table above shows a stock trading at over a 150 times its price to earnings ratio vs. a peer group trading at 11 times and on a forward Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization (EV/EBITDA) times 40 vs. the peer group of 6X according to Reuters. Yet what is its business model? Not much different than PXD’s to be honest, if not worse. It burned through $558 million in cash in the first quarter of this year vs. $455 million in the fourth quarter 2014 and $312 million in the previous quarter! At this rate, it will have burned through all of its $1.9 billion in cash by this time next year.
This despite the very real possibility that Tesla won’t make its projections as a result of low gas prices and an outlook hinged on the speculative future of a single car model (Model X) coming in the first quarter of 2016. This lower cost mainstream crossover will literally determine its future and ability to sustain its monstrous cash burn. Is PXD’s future that risky? Is it dependent on a single well to make or break its future? No.
PXD, on the other hand, is generating $1.6 billion in cash operationally and has proven reserves worth tens of billions. Yes, it is true many of the smaller producers aren’t in the same boat and have flawed business models and are unlikely to survive the down turn. This is helping to fuel negative sentiment for sure. But PXD surely isn’t one of those at risk given its low leverage.
Investors who have money with hedge funds or long-only funds better start asking why managers are doing what they are doing because it doesn’t seem rational. Tesla’s share price seems to be driven by bias and excitement rather than any sort of investment rationale. Related: Russia Taking Full Advantage Of Greek Crisis
E&P companies should also start asking the same questions about the banks which they rely upon, as they are in part responsible for the recommendation of one sector over the other.
On a final note, the E&P sector should have realized by now that the investment community has become increasing hostile to its model, as well as the prospect of rising energy prices. But it does not help their cause to foster the perception that supply will increase indefinitely. As we witnessed over the past week with rig count additions, the perception of abundance only translates to lower prices. Oil executives that trumpet the abundance are essentially shooting themselves in the foot.
Until sentiment improves and the media stops distorting the supply/demand picture, this will continue. Fundamentals often don’t matter as much as ideology or media, even among seasoned investors. The question is when will the energy sector realize this? Once it does, the consolidation will start and then, and only then, sector valuations will improve.
By Leonard Brecken of Oilprice.com
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