Yesterday’s quarterly report from Conoco-Philips (COP) is showing a renewed trend among oil companies, mirroring the report of Anadarko Petroleum (APC) a few days earlier. Both are reporting negative earnings while cutting capex for the remainder of 2017. Capex cuts were epidemic in 2015 and 2016, as oil companies reeled from cratering oil prices. But 2017 was signaled by most oil companies as a green light year, where they chose to again increase capex in hopes that the bust cycle for oil was ending.
It hasn’t turned out that way.
And while capex adjustments from oil companies have very few immediate effects on production, earnings and oil prices, they have a very definite and clear effect on them in the longer term.
Now would be a good time to talk about that longer term and the opportunity it will present, now that several oil companies, and likely most of the others yet to report, will continue this capital expenditure slashing for the rest of 2017. It is a pillar of my long-term thesis of oil prices again breaching $100 a barrel and even making new historic highs.
Oil’s latest bust cycle, which has brought prices well below $70 a barrel for much of the last three years has delivered two difficulties to oil companies: First, it has made much of their current production unprofitable, or only marginally so – witness the stream of losses that continue to swamp oil companies.
But second, it has absolutely decimated the free cash flow oil companies use to explore and find new wells, pay for drill leases and haul heavy machinery and transport infrastructure to oil sands mines. Industry-wide, oil exploration capex is down 70% from 2014 to the end of 2016, a fraction of what’s been historically necessary to keep up with ever increasing demand for oil. This fact of life for oil companies is mostly lost upon the valuations that Wall Street applies to oil stocks, but is a critical fact for us looking to make solid, long-term energy investments. Stock markets may be said to be future-looking devices, but for oil, their vision does not actually extend very far at all.
There are few signs of this capex decimation anywhere else either. We’re definitely in the midst of a unique boom time for global production, not only in U.S. shale plays (where we have seen the most press coverage), but also with conventional production among OPEC and other Middle East producers. For example, there was a time not long ago when Saudi Arabia’s oil production was thought to be limited at 9 million barrels a day. Today, Saudi production is well over 10 million barrels a day, and their ‘swing capacity’, a hot topic five years ago, almost never gets questioned today. Both Iran and Iraq could really ramp their production as well, given more investment and a quieter geopolitical atmosphere.
But these oil gluts must end soon. Global demand for oil not only continues to increase, but as a historical measure, is trending higher than ever before, despite the wishful thinking of advocates for renewable energy sources. Complex oil production, in long-term deep-water and Arctic projects and with more difficult conventional projects in Asia and the Middle East have been all but scrapped since oil’s price cratered in 2014 and are being shunned again this Summer of 2017 – and that oil was being depended upon to meet the increasing demand in 2018, 2019, 2020 and beyond.
We are headed for a very real and very deep oil supply shortage that will hit this market like a ton of bricks – and its arrival is anything but far in the future.
The opportunity today lies in the fact that oil stocks are being valued as they always have – in terms of current earnings and production growth. And we know on both counts, these are not the metrics we really need for a profitable long-term investment. What we’re really looking for is a solid balance sheet, and a lot of potentially cheap oil production that requires as little investment as possible to bring on line. We’d also like a share valuation more based on the ‘old analyst’ metrics of growth and current earnings, which lead to beleaguered stocks and deep value. Using this plan is why I’ve been concentrating efforts in Permian producers with lots of prime acreage and disciplined growth plans, like Cimarex (XEC), EOG Resources (EOG) and SM Energy (SM).