There is a saying in the oil industry that “the cure for low prices is low prices.” Behavior in the domestic oil industry is changing dramatically as capital budgets are slashed, employment is reduced, and a focus on servicing, if not cutting debt, becomes a priority.
We expect that capital will not flow to the industry, new wells will not be drilled, and old wells will be shut down. Furthermore, wells shut down today might not return tomorrow, as sub-surface damage is possible after prolonged disuse. This industry response will probably persist until oil prices approach $40 - $50 per barrel. In short, the economics of supply and demand, combined with the financial demands of credit and capital allocation, will make this change in behavior a necessity.
So far, the U.S., which is the world’s leading oil producer, has not committed to making substantial cuts in production, in part because production comes from private companies unlike with most OPEC nations where governments control the output. Still, U.S. producers may have no choice but to cut production.
In fact, at current physical market prices, most U.S. producers can no longer produce oil profitably. We believe that hundreds of U.S. oil producers could file for bankruptcy this year and in 2021 if oil stays at this price level.
While travel will eventually pick up as the effects of the pandemic subside, it is expected to be many months before travel returns to previous levels and inventories are drawn down. But the industry is cyclical and there will be an upcycle at some point.
Many companies that had funded themselves in the high yield bond market had hedged their price risk at about $50, so they have bought some time. However, there are significant debt maturities that will have to be refinanced this year and through 2022. It is possible after this severe downcycle concludes, surviving companies will be far more financially disciplined and attractive to generalist investors.
With energy stock and bond prices at such distressed levels, some opportunities are emerging – but it’s still early. Energy bonds of some surviving companies will provide equity-like returns for long-term investors. We are focusing on companies with no refinancing needs until 2025 and that have superior acreage positions which can be developed profitably at low breakeven oil prices. The bonds of some of these possible survivors are trading at 50 to 60 cents on the dollar.
In the equity market, we are targeting quality companies that are well-positioned with superior returns on invested capital, line-of-sight to improved returns, with trusted management teams. For a commodity-reliant industry where the low-cost provider has the long-term advantage, these characteristics are particularly important. Commodity price risk is inherent for energy companies. We are favorable toward companies that do not layer financial leverage on top of commodity leverage. We have taken advantage of severe price movements among energy equities to further increase allocations to the highest quality companies.