The U.S. oil and gas rig count continues to fall – having plummeted by 74 rigs for the week ending on January 16 – in a clear sign that the contraction will likely persist for some time.
A fresh wave of layoffs and spending cuts were announced this past week. Baker Hughes (NYSE: BHI) said that it would slash 7,000 from its payrolls, for example.
Oil Prices Go Down…And Back Up
As rigs and roughnecks disappear from the oil patch, production will decline. However, it will not decline right away – there tends to be several month lag period between a reduced rig count and slower production. That period of time could be about two to five months, meaning U.S. oil production could begin to feel the pinch in second quarter.
There are a series of other signs that would indicate that oil prices are bottoming out. Although one data point doesn’t confirm a trend, U.S. oil production fell by 6,000 barrels per day during the second week of January. More cutbacks will eventually correct a supply glut.
OPEC’s Secretary-General spoke at the Davos World Economic Forum and said that he thinks prices will stabilize in the $45 to $50 range and then rebound. OPEC is also predicting that low oil prices will stoke demand, which should send prices back up. Early signs from the U.S. reaffirm this view – U.S. gasoline demand is at an all-time high.
Capitalizing on the Rebound
There is a huge opportunity for investors to find some value picks that have been beaten down by the markets. To be sure, exploration companies could see rougher waters ahead for some months and there could even be some bankruptcies, but when the dust settles and oil prices rise, there will be a lot of money made on the companies that rebound aggressively.
As we have discussed in this column in recent weeks, avoid some of the riskiest upstream companies in the near term. But there are several shale producers that have robust balance sheets, low debt, and a compelling case for future growth.
And for that, return to the tried and true, the best of the best in their respective regions. EOG Resources (NYSE: EOG), one of the best managed Texas shale producers, comes in at the top of the list. With producing assets in the Eagle Ford, Barnett, Permian, Marcellus, Bakken, and more, EOG Resources is sitting on some of the best acreage in North America and has consistently impressed. The company increased oil production by 31% in 2014, with a three-year CAGR of 36%.
The company says that it can earn a 10% return or better on most of its operations when oil prices are at just $40 per barrel. EOG increased its dividend last year and is even mulling another dividend increase this year, underscoring management’s confidence. As the largest oil producer in the Lower 48 – yes, that’s right – EOG won’t be shutting in production to make room for its competitors, it will be other companies that shut in and make room for EOG.
Another strong upstream producer is Devon Energy (NYSE: DVN), a middle-tier oil producer in the Eagle Ford, Permian, Rockies, and Canada’s heavy oil sands. Devon saw its production rise by 35% in 2014 and, driven by its Eagle Ford assets, Devon expects another 20% to 25% expansion this year. But more important than straightforward production figures is the margin on a per barrel basis. Devon reported a 37% increase in its margin per barrel between 2013 and 2014. It achieved that by keeping a lid on costs, divesting away from lower margin assets, and focusing on highly profitable areas.
Insulating it from the low oil price environment, Devon hedged a majority of its fourth quarter production well above current prices. Even better, more than half of its 2015 production is hedged above $90 per barrel. That is significant, and it’s a big reason why Devon’s share price has not been assaulted the way some of its competitors have been.
Looking at one of the majors, ExxonMobil (NYSE: XOM) offers a safe position for investors looking to ride out the storm. Highly diversified, ExxonMobil saw its third quarter earnings rise last year by $200 million, largely due to better margins in its refining and chemical divisions. It also improved its earnings per share by 5.6% year-on-year in the most recent quarter. As one of the largest privately-held companies in the world, ExxonMobil does not offer a huge upside, but after factoring in the safety, plus a 3.01% dividend yield, it starts to look pretty attractive in the current market. If oil prices stay low for a quite a while, ExxonMobil offers some modest returns coupled with security, which is important during these unpredictable times.
Kinder Morgan (NYSE: KMI) is another company well positioned to ride out the storm. Its major holdings in midstream assets insulate the company from oil price swings. Kinder Morgan runs some of the largest natural gas pipelines in the country, infrastructure that has not seen a slowdown in demand. It just approved a 10% increase in its dividend, up to $0.45 per quarter. While that is not necessarily a good thing for investors who have yet to take a position, as with EOG, it is an indication of the positive trajectory the company is heading in while the rest of the industry is considering dividend cuts. Kinder Morgan expects to increase its dividends by another 16% this year.
Better yet, with many of its competitors crouched in a defensive position due to low oil prices, Kinder Morgan is going on the offensive. Taking advantage of the distressed situation that Continental Resources (NYSE: CLR) finds itself in, Kinder Morgan will buy Hiland Partners LP for $3 billion, a major pipeline operator in North Dakota. Hiland operates the Double H oil pipeline, which will carry 100,000 barrels of oil from North Dakota to Wyoming when it begins operation in 2016. The pipeline was financed by Continental and its CEO Harold Hamm, who used some of his personal cash to pay for the pipeline. He’s going through a messy divorce and needs liquidity. Continental, for its part, took a misguided position on its hedges, and is highly exposed to low oil prices.
Continental’s loss is Kinder Morgan’s gain, which up until this point did not have a position in the Bakken. Rather than play defensively during the current oil bust, Kinder Morgan snapped up a foothold in the Bakken that will position it for future growth.
We have tried to steer investors away from some of the riskier upstream producers over the past few months, preferring midstream, downstream, and ETF positions. However, there are some glimmers of light at the end of the tunnel. U.S. production should begin to slow and maybe even contract towards the middle of this year, demand is already picking up, and prices should rebound.
Again there is still quite a bit of room for weak companies to fall, but if investors stick with some of the stronger players, they could find bargain positions in companies that will emerge on the other side largely unscathed.