Energy: The Perils of 'Volume over Value'
Easy money has caused oil producers to drill wells when they shouldn’t. Is the industry due for a change of strategy?
There’s an ongoing narrative about the energy industry that says exploration and production (E&P) companies are making money in unconventional shale plays, even with oil selling for only $50 a barrel. This is touted as a positive trend. But a deeper dive into energy company fundamentals suggests a vastly different story — one that prioritizes production volume over economic value. Below, three of our investment managers discuss what they’re hearing from energy company executives, what they’re seeing on company balance sheets, and how that colors their view of opportunities in this sector.
What’s your view of energy companies today?
Norm MacDonald, Portfolio Manager, Invesco Energy Fund: When you look at a lot of these US onshore shale companies, they’re not providing value-added growth. Some executives will tell you that their internal rates of return are at the 70% or 80% level, but in my view it’s just not translating to bottom-line earnings per share (EPS) growth or return on capital employed. It’s a big cloud.
The problem is a lack of discipline has delayed a recovery in a commodity that has historically worked through supply and demand imbalances in a pretty timely fashion. I am a little bit shocked how long it’s taken for many executives to adopt a mindset of proper capital allocation. The industry in the US has shifted to a “volume over value” strategy — producing as much as they can despite the economics. I saw that happen in the mining space about five to seven years ago, and it took a while to clear up.
A lot of people say that shale producers are now able to generate an economic profit at $50 a barrel, but in my opinion that’s just not the case.
Christopher Godfrey, Equities Analyst, Invesco Small-Cap Growth team: Entering 2017, I expected the industry would work through its excess oil inventories as supply growth would be outpaced by demand growth, which would leave the oil market balanced by the end of 2017. Inventory draws during the first half of 2017 were below my expectations as a result of the unexpected addition of Libyan and Nigerian production and US supply growth that outpaced my expectations. However, we are beginning to see positive signs of global inventories drawing to more normalized levels, and I expect this to continue throughout the second half of 2017.
US supply growth has been supported by robust capital availability in 2016. Many of the US shale producers repaired their balance sheets in 2016 through a combination of equity issuance that reduced debt and bond offerings that extended debt maturities. Cleaner balance sheets combined with active commodity hedging programs has allowed the industry to outspend cash flow in 2017 in a meaningful way, and they’ll likely be able to continue this through 2018. At a recent meeting with executives at an energy conference in Houston, I was struck by the cavalier tone of the E&P management teams. Despite oil trading at $42 on the day of the conference,1 management teams remained committed to current activity levels not only through 2017, but likely into 2018.
I’m concerned that inventory levels may not be meaningfully reduced when the current OPEC agreement expires in the first quarter of 2018. At this point, OPEC production could be added to the market at the same time that US supply is growing at peak levels. This scenario would likely lead to lower oil prices.
Scott Roberts, Head of High Yield, Invesco Fixed Income: So one of the themes that we look for in any sector is really a change in behavior by companies when you’ve got macroeconomic trends going either for you or against you. The fact that we’re not seeing that today stems from the ability of these companies to raise capital at will, either in the debt markets or equity markets, over the past 14 to 16 months. In my view, that’s changing, and it’s changing right now. The energy component of the high yield market is quite high — anywhere from 12% to 15% depending on which index you’re looking at — which means that the price of oil has an impact on debt markets. What I’ve seen in the past few weeks is that investors are starting to pull away from wanting this type of exposure. Companies are slow to react to that, but when they realize what it’s going to cost them to finance their next deal, they may start to change behavior.
In the short run, spending behavior might start to change if we slip below $40 per barrel for oil. I don’t believe companies would immediately cut their spending plans, but they may start to question how flexible they need to be going forward.
How are you positioned in the energy sector?
Norm MacDonald: I look for companies that have a disciplined approach to capital allocation, and if real economic returns are not there, they won’t spend an exorbitant amount just to show volume growth.
In a nutshell, Invesco Energy Fund is overweight select E&P names, and underweight integrated oil companies (which have activities across the energy complex, from drilling to refining). I believe when oil is priced at $45 a barrel, it’s going to be very tough for these global integrated companies to cover their dividend payments. From a service perspective, I favor diversified service providers rather than drilling companies.
Christopher Godfrey: Despite my less than optimistic view on longer-term oil prices, we are currently overweight energy, specifically E&P companies, in Invesco Small Cap Equity Fund and Invesco Small Cap Growth Fund. That’s because we believe we will have inventory normalization in the second half of the year, and I’m hesitant to change that overweight positioning given what I think will be a better fundamental backdrop in the second half of the year combined with extreme negative sentiment toward both the commodity and the stocks currently. If fundamentals improve in the second half of the year, that may allow the stocks to reverse their underperformance relative to both crude oil and the overall market. While difficult to predict, there is also opportunity for the recent supply surge from Libya and Nigeria to reverse as both countries are producing at multi-year highs. We have a preference for companies in the Permian Basin and high-quality companies that can weather any price environment.
Scott Roberts: Invesco High Yield Fund has a slight underweight to energy. We have a large underweight in offshore drilling companies, which are in a troubled spot this year and into 2018, in our view.
Our focus on the E&P side has been heavy in Permian Basin producers. We like the companies we own, but we do realize that in the short run, we could see oil prices dip lower than $40 a barrel. If we do, that’s an opportunity to add to some of the names that we’re certainly favorable on.
What are you looking for going forward?
Norm MacDonald: For me, it comes back to return on capital employed. Show me how you’re making an economic return at today’s oil price level based off the accounting math that we all know. The math has to line up.
Christopher Godfrey: I’d like to see some sort of capital discipline — anything that’s going to stabilize or reduce the rig count activity level.
Scott Roberts: I’m looking for a change in behavior. I want to hear from companies what their view is and at what point they would adjust their capex budgets. Also, I’m looking for some change in OPEC thinking, or for a production disruption in Libya or Nigeria. That would certainly change the global balance.
1 Source: Energy Information Administration
CFA® Portfolio Manager
Norman MacDonald is a portfolio manager for Invesco Energy Fund and Invesco Gold & Precious Metals Fund. Mr. MacDonald joined Invesco in 2008 as portfolio manager for Invesco’s Canadian distributed sector mutual funds.
Mr. MacDonald began his investment career in 1994 at State Street Bank and Trust as a derivatives analyst. He later moved to Ontario Teachers’ Pension Plan Board, where he worked for three years in progressive roles from research assistant to portfolio manager. His next role was as a vice president and partner at Beutel, Goodman & Co. Ltd. Prior to joining Invesco, Mr. McDonald was a vice president and portfolio manager at Salida Capital Corp.
He earned a BComm from the University of Windsor and is a CFA charterholder.
CFA® Equities Analyst
Christopher Godfrey is an Equities Analyst covering the financial services and energy sectors within Invesco’s Small Cap team.
Mr. Godfrey joined Invesco in 2013 and has five years of commercial banking experience. Previously, as a financial analyst with Regions Business Capital, he constructed financial projection models, analyzed historical financial statements, compiled industry research and synthesized underwriting data for commercial loans.
Mr. Godfrey earned his MBA at the Goizueta Business School at Emory University with a concentration in finance, which also included an analyst internship with Invesco’s Small Cap team during the summer of 2012. He earned a BA degree in economics from Washington & Lee University and is a CFA charterholder.
CFA® Head of High Yield Investments
Scott Roberts is Head of the High Yield team for Invesco Fixed Income.
Mr. Roberts joined Invesco in 2000 as a high yield analyst and was named portfolio manager in 2009. Previously, he was a high yield analyst and trader with Van Kampen Investment Advisory Corp. He entered the industry in 1995.
Mr. Roberts earned a BBA degree in finance from the University of Houston. He is a CFA charterholder.
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Energy: The perils of ‘volume over value’ by Invesco