A version of this story appears in the October 2017 edition of Oil and Gas Investor. Subscribe to the magazine here.

With the recent trough in energy sentiment approximating all-time lows, it’s easy to assume that brighter days must lie ahead. But how did sentiment crumble to the point that long-time energy observers cite “capitulation?” Others compare recent conditions to Saudi Arabia’s abandonment of its swing producer role in 1986, or investors’ exodus from energy in the dot-com mania in 1999.

Certainly, the ranks of energy investors have thinned markedly. Energy’s weighting in the S&P 500 has slumped to just 5.7%, down from a peak of 16.2%. One energy specialist estimates that a score or more of energy hedge funds will close up shop. On the commodity side, famed crude oil trader Andy Hall plans to shut down his main fund at Astenbeck Capital Management LLC following double-digit losses.

"For the first time in a generation there are good, low-cost companies that are investable and can work in a flat commodity price environment," said John Dowd, portfolio manager at Fidelity Management & Research Co.

Recent sentiment in the energy sector, which has trailed the S&P for most of the first half of 2017, is described as “abysmal” by John Dowd, a portfolio manager of two energy funds at Boston-based Fidelity Management & Research Co. However, while energy clearly has its work cut out to win back skeptical investors, there are cost-advantaged E&Ps with the necessary scale and superior execution ability on sale currently at attractive prices, Dowd said.

The sell-off in energy has seen E&P valuations shrink dramatically—in some cases down to almost half the prior low double-digit multiples of EBITDA. A recent Simmons & Co. report noted that its coverage group traded at an average of just 6.6x unhedged 2018 EBITDA, assuming a price deck into perpetuity of $50 per barrel (bbl) for West Texas Intermediate (WTI) and $3 per metric cubic feet for natural gas. Moreover, oil-oriented names traded at a 15% discount to net asset value (NAV) and gassy names at a 26% discount to NAV.

According to Dowd, the energy sector’s recent fall from grace has reached levels that offer remarkable values, especially for E&Ps with advantaged cost structures and strong balance sheets.

“On an enterprise value per flowing barrel of production metric, valuations in the E&P sector are now cheaper than they were when oil was at $28 per barrel,” he said. “Sentiment is extraordinarily bearish.”

How did energy descend to such depths?

Historically, underperformance in the energy sector tended to result from a decline in demand during an economic recession. However, in today’s “unique” set of circumstances, it has been supply growth—the “elasticity of supply” possible from short-cycle unconventional production—that has been the catalyst for the sector’s fall from favor, observed Dowd.

This has presented challenges but is also creating opportunities for long-term investors, he said.

“To the extent, the U.S. industry can accelerate production in a $55 to $60 per barrel world, that takes some of the upside optionality in the commodity off the table,” noted Dowd. “Many investors play energy for a recovery in the commodity. People are questioning, ‘Why invest in energy if the upside is limited?’

“The flip side is that for the first time in a generation there are good, low-cost companies that are investable and can work in a flat commodity price environment,” he continued. “And while the upside optionality is limited by the elasticity of supply, it provides for a great stock-picking environment. You don’t need to invest on the premise of a commodity price increase; earnings can go up with volume growth, too, and with cost reductions.”

The Restraints

Aside from generalist investors’ reluctance to get involved in energy, what else is holding them back?

“I think a lot of investors have given up on the sector due to the lack of capital discipline—full stop,” Dowd said. “The idea that certain E&Ps are low-cost companies is by and large not yet showing up in the results on E&Ps’ financial statements. When you look at the industry, it’s barely profitable on a GAAP [generally accepted accounting principles] basis. It’s still a nice theory that these companies can thrive in a low commodity price environment.

“To attract generalist investors back into the sector, E&Ps need to deliver earnings per share—not production growth per debt-adjusted share, not reserve growth, not outstanding new well results, but actual earnings per share. Some companies are embracing this discipline and are focused on improving returns on capital and earnings per share. And they’re clearly doing better than the rest of the industry.”

A further obstacle for investors has been the macro outlook, which has not been easy to interpret for those looking for clear signals as to where demand and supply intersect. And when in doubt, investors have tended to sell first and ask questions later.

“This issue is the elasticity of U.S. supply, and that works both ways,” observed Dowd. “At $60 per barrel, we would see production in the U.S. ramp up materially. But at $40 per barrel, production growth grinds to a halt with the cost structure we have today.”

The specter of low oil prices and risk of little growth have likely added to investor unease, according to Dowd. “I think energy sentiment is reflecting both the idea that we’re going to have permanently low oil prices and the perception that the industry cannot actually grow,” he said.

But, from a macro viewpoint, it is inconsistent to imagine both scenarios unfolding simultaneously, as it is broad U.S. oil development—rather than minimal growth—that is more likely to hold down oil prices, noted Dowd.

“The only reason we should have prolonged low oil prices is if the industry delivers on its volume growth expectations,” he said. “A lot of high-quality names that have demonstrated advantaged cost structures, and have solid acreage positions, have the potential to grow in this commodity price environment. They have been sold off as aggressively, if not more so, relative to their benchmark.”

The energy industry is going “through a technological revolution,” according to Dowd. “And in that world, it’s absolutely necessary to be investing in the companies with the disruptive technology that is putting the pressure on oil prices. From an investment viewpoint, it’s OK if you are invested in the disruptors; but if you’re invested in the disruptees, it’s very, very difficult.”

In this technology-driven environment, “it’s all about execution,” said Dowd, citing EOG Resources Inc. (NYSE: EOG) as the “poster child” of best practices. EOG is among the top holdings in the two funds managed by Dowd: the Fidelity Select Energy Portfolio and the Fidelity Select Natural Resources Portfolio.

“What EOG has been doing with information technology to optimize its drilling and other operations is, I think, second to none,” said the Fidelity portfolio manager. “The confluence of scale, data management and teamwork has been leading to superior well results and a continually improving cost structure. The company’s execution has been very special.”

Dowd held out EOG as an example of an E&P that has been able to achieve outperformance in a mostly range-bound commodity price environment. He calculated that over the last decade EOG’s stock was up 164% vs. 109% for the S&P 500, even as oil prices slid by 32%.

“That happened not because oil prices went up, but because the company’s cost structure came down dramatically,” Dowd said. “And I think there’s the potential for a lot of E&Ps to do that.”

For the unconventional sector broadly, Dowd pointed to attractive economics attained by the better producers. Against well costs of $5.5- to $7.5 million, including land, for example, some of the better E&Ps are able to recoup $5.5- to $6 million in revenues over the first six months, he said. But the range of well costs remains “extraordinarily wide” across the industry, and land costs also vary. Some E&Ps, such as Pioneer Natural Resources Co. (NYSE: PXD), enjoy an advantage in being able to drill on a very substantial legacy acreage position, he added.

Now that the industry is exiting a “transition phase,” in which it has largely consolidated its acreage positions and honed drilling and completion practices, the potential exists for “dramatic improvements” in returns on capital, provided the industry can exercise greater capital discipline, according to Dowd.

“The biggest risk is the industry continues to overinvest,” he said. “If the industry wants to make more money, they should be more capital disciplined. There has been too easy access to capital, too many companies raising equity to finance expansions. The successful stocks are those that have been the more capital efficient. Maybe production growth slows a bit, and return on capital improves dramatically.”

On the commodity side, Dowd offered some encouragement as to a drawdown in crude and product inventories being at last in sight. In terms of absolute barrels, OECD inventories will be close to—but not quite at—the five-year historical average by the end of this year, he forecast, assuming roughly stable levels of OPEC compliance. If measured on a days-of-supply basis, the inventory overhang is on target to be worked off by year-end, he added.

Dan Rice, lead portfolio manager of energy strategy at GRT Capital Partners, believes "you're not going to see much additional conventional production coming onstream" until oil is at least $65/bbl.

“I’ve been blown away by how quickly inventories have contracted over the past six months,” he said.

Also, looking at the futures market in mid-August, Dowd noted that the prompt or near-month Brent futures contract was trading at a small premium to subsequent contracts, indicating “backwardation” in the commodity curve. Coupled with the prompt WTI contract no longer trading at a substantial discount to subsequent contracts, this “would tell you that the inventory situation is no longer a major issue.”

While more normalized inventory levels may help sentiment, Dowd expects exit-2018 over exit-2017 production growth in the U.S. to come in closer to the low end of a 700,000 to 1 million bbl/d (MMbbl/d) range. To come in higher would depend on access to capital from Wall Street, where the appetite is currently “minimal,” he said.

What changes the mindset of buysiders who have—at no opportunity cost—been able to ignore oil?

“It comes down to execution. The idea of good solid returns for a company has to move from the traditional marketing economics in slide decks to the GAAP financial statements,” Dowd said. What is surprising, he added, was how closely the cost structures of the best E&Ps are now approaching their “idealized slide deck economics,” especially at a time when larger producers in the U.S. and internationally are struggling under relatively high-cost structures.

“The incremental well returns are very, very attractive, and they’re competitive on a global scale,” he continued. “It’s massively bullish for the companies that are prosecuting these programs.”

With greater capital discipline, strong execution in the field and a drive to demonstrate earnings to investors, what else can E&Ps do to attract investors?

“There’s nothing wrong with dividends, or share repurchases, or returning cash to shareholders.”

Dan Rice is a long-time energy investor whose career includes decades of experience in managing energy money at State Street Research & Management Co., BlackRock Inc., GRT Capital Partners and, increasingly of late, his family.

Rice sees the global energy picture increasingly splitting into “haves” and “have-nots,” divided into two camps along finding and development (F&D) cost lines. On one side are the Gulf OPEC countries (plus partner Russia) and the low-cost U.S. shale producers, and on the other side are mainly non-OPEC, non-U.S. producers with dramatically higher F&D costs.

Ultimately, this division will come to the fore in strengthening crude prices, according to Rice. But, for the moment, investor sentiment has been as bad—or worse—than even prior slumps in 1986 and 1999.

“Sentiment is worse than the end of 1999, when the Internet sector was sucking up all the money to invest, and energy was treated as the red-headed stepchild,” recalled Rice. “And it’s like 1986, when the Saudis decided not to be the swing producer, and the next couple of years were pretty ugly.”

Other factors are also at work. In addition to a sub-6% weighting in the S&P 500, the energy sector scores even worse in the exchange-traded fund (ETF) arena, where energy makes up only a little more than 1% of all ETFs, down from 3% to 4% historically. Passive investing—a strategy designed to replicate market performance—has also grown in size and tends to add money to rising market sectors over those out-of-favor sectors, like energy.

“Passive investing will work until it doesn’t work,” cautioned Rice. “And when it doesn’t, it will be a horror show, because there’s no way out.”

While seemingly overlooked by investors, F&D costs for the U.S. unconventional sector have declined from around $12/bbl to $6 to $7/bbl, and “they still have room to improve,” said Rice. As more information is gleaned on downhole procedures, he added, “I’m sure they can make additional refinements to take it closer to $5 per barrel, which is Middle East economics.”

Rice puts OPEC production at about 40 MMbbl/d, including condensates and NGL, and estimates U.S. unconventional production at 5 to 10 MMbbl/d, assuming it grows by 800,000 bbl/d annually. This makes for roughly 50 MMbbl/d of “highly economic” production, or half of what will be needed to meet global demand, assuming a 100-MMbbl/d run-rate by year-end 2018.

As for meeting the other half of global demand, this will be dependent on production carrying higher F&D costs, as much as “five to 10 times higher than the two golden areas,” said Rice. “You’ll have half the supply at really low F&D costs of $6 to $7/bbl and the other half at levels up to $50/bbl. I haven’t ever seen a schism in F&D costs that big.”

The “elephant in the room” in Rice’s view is the majors’ inaction in terms of getting bigger in the shale plays. This would be a logical step—and certainly buoy investor spirits—given the importance of being a low-cost producer in a commodity business.

“What’s surprised me is that there haven’t been more takeovers across the low-cost segment of the industry,” he said. Even considering ExxonMobil Corp.’s (NYSE: XOM) acquisition of Bass family assets in the Permian Basin for more than $5 billion, “that gives them only a 10-year inventory on their existing acreage base.”

And whereas historically the custom was to do only friendly takeovers, dictated by the need to gain access to proprietary seismic to assess asset values, there is little reason for hostile takeovers not to occur given that data is more easily available on key factors such as the number and extent of productive zones, according to Rice.

“In a conventional world, you need to be friendly; in a shale world, you don’t need to be friendly.”

In terms of oil prices as a catalyst to attract investors, “we think we’re rapidly approaching a point at which inventories will be back in line, and oil prices will spike as the one-way trade starts to reverse,” said Rice. Moreover, the lack of major project start-ups is expected to bite regarding global production declines starting in late 2018 to early 2019. “And there’s no way to arrest that through 2022.”

Discounted Valuations

Houston-based Bison Interests LLC was co-founded by Josh Young and Carter Higley in 2015 with an investment philosophy largely aligned with current market conditions: deep value investing in an area that is significantly out of favor and, as a result, is “unloved and ignored.” The team has set out to find deeply discounted valuations, and that has helped protect value for investors this year.

Even so, “it’s been a bloodbath out there,” Young said. “Sentiment couldn’t be worse. We’re starting to see a washout even in places where there had been significant resilience, like the Permian and the Scoop/Stack names. Their equities have come under significant pressure, too.”

Bison’s investors mainly comprise family offices and high-net-worth investors, as well as a university endowment. Several high-net-worth clients have ties to the energy industry, including oil and gas private equity. Bison is focused on purchasing and managing public equities. In a portfolio of roughly $60 million, it typically has 12 to 20 positions, including six to eight “top positions.”

The fund resembles a private equity fund in that it offers “patient capital,” according to Young. “We’re focused on long-term capital appreciation through a portfolio of heavily undervalued assets that are well-managed,” he said. “Just on cash flows at current commodity prices, energy is one of the few places where you can get value in an overvalued stock market.”

Bison’s mandate provides for energy deals in onshore U.S. and Canada. Investments are focused primarily on the upstream sector, with “occasional” midstream and service deals. Investing in Canada is by no means an after-thought: over half of fund assets are allocated to the Canadian energy sector. Young sits on the board of Calgary, Alberta-based RMP Energy Inc., in which Bison has a 9.5% holding.

In particular, Young is attracted to the Montney play, where acreage has been acquired—and is still in some places available—at deeply discounted valuations as compared to the more elevated prices paid in the Permian. In addition, even with well economics that can offer 100%-plus rates of return, stocks can be bought at below the already discounted net present value of future cash flows, he said.

One of the biggest drivers of returns in the Montney has been the rapid improvements in new well productivity, Young noted. “Currently, it’s two years behind the Permian but catching up fast,” he said. “The resource itself is very similar to the Permian. Price realizations are strong, and cash flows at the wellhead are competitive with the very best areas of the Permian.”

As an example of improved productivity, Young cited Montney wells costing slightly more than $3.5 million that have shown 180-day production rates of more than 2,400 barrels of oil equivalent per day, with oil cuts of 40% and NGL cuts of 15%.

Bison has also bought “aggregators” of conventional production in Canada, who can typically purchase production from small mom-and-pop companies with long-lived, low-decline reserves for 4x or 5x cash flows, according to Young. In turn, Bison aims to own the E&P’s equity at a still lower multiple, given the “extreme dislocation we’re seeing.” One example is its investment in Journey Energy Inc. in Calgary.

"We're starting to see a washout even in places where there had been significant resilience, like the Permian and the Scoop/Stack names," said Josh Young, co-founder of Bison Interests LLC.

“Journey can show very capital efficient growth, even though output is conventional,” he said. “There typically are remediation costs, but frequently you can add significant production for minimal costs. Journey’s cash flow is up almost three times from last year, while spending within cash flow.”

In the U.S., Bison has exposure to a number of basins. Although the Delaware is viewed as a “favored” basin—so not an obvious selection for a deep value manager—Bison does have exposure to the eastern side of the play near Ward and Pecos counties, Texas, through a heavily discounted, small-cap producer.

But deep value managers don’t compete with the crowd—admittedly, not hard in today’s oil and gas climate.

“We go where others aren’t,” said Young. “We like to buy names that are off the radar.”

Chris Sheehan can be reached at csheehan@hartenergy.com.

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