Energy research analyst David Deckelbaum likened the recent crude rally following several years of living below the per-barrel poverty line to the anticipation of an all-you-can-eat buffet.
“It feels like we’ve been camping outside of a buffet for three years, and when it finally opens, there are only salad plates, and you can only go up one time. You see the price of crude going back into the $60s, and the equities don’t really care. So what gives?”
Investor apathy gives. The E&P sector has experienced a dramatic decoupling of fundamentals and stock performance, said Deckelbaum, director for KeyBanc Capital Markets and who spoke to a NAPE audience in Houston recently—particularly around crude. E&P investors haven’t made a return on investment for the past several years, he noted, and other sectors—such as Consumer Discretionary—have outpaced E&P in excess of 200%. “The generalists haven’t come back.”
While all resource basins lagged the move in crude last year, even the formidable Permian Basin, once the hot ticket, underperformed other basins in 2017.
“You could say it’s because the basin got overheated, but that’s not necessarily true if you consider most companies are trying to spend within cash flow and grow 20% or so. It’s just a matter of losing your seat at the table with most public investors.”
Alas, the sector is now considered out of favor, and the fix might not come quick. So how do you get investors re-engaged with the energy sector?
Not by wishing for $75 WTI.
Even if investment managers believe that, Deckelbaum said, if they invest equal weight to benchmark (about 6% of the S&P 500), “you’re not going to get your face ripped off. But if you go overweight to benchmark and you’re wrong, you do. [Then] you’re going to have to explain to your investors why you were excited about a sector that wasn’t technology.”
Not by timing the market cycle upswing.
Most sector upcycles average three years, and down cycles one and some change, he said. But the oil and gas sector is evenly skewed: you can spend an equal amount of time in an up or down cycle. And the risk-reward has the most negative skew compared to all other sectors.
“In other sectors people see the opportunity to stay with the upcycle a bit longer, and they don’t have to dabble with the fundamentals.” Regarding oil and gas—“Now they’re just willing to sit on the sidelines.”
And it’s not in selling efficiency gains. While the industry has reduced well costs by some 30% since 2014, “now you see it going the other way. Efficiency gains are undoubtedly flatlining.”
The answer to garnering investor attention once again, said Deckelbaum, is consolidation.
“It’s an industry that’s starving for consolidation. There are way too many public companies out there all doing the same thing. You haven’t seen IPOs in quite some time. You have to make room for new ones to come out.”
E&Ps aren’t consolidating as rapidly as they once did, he noted. Perhaps, maybe, the large consolidator is just not there anymore. But if you have a shale portfolio with a long-lived inventory, if you have the ability to grow within cash flow, “you probably don’t need as many people around managing these assets. We have to look at synergies.”
Boards are now pushing management teams to be compensated on returns, which is fine, he said, but nobody is incentivized to sell their company by doing so, as insider ownership in the sector is only about 1%. That compares to about 5% CEO ownership for most other S&P 500 companies.
“Management needs to be more aggressively compensated with equity instead of bonuses and cash,” he proposed. “They also should have some regressive change-of-control provisions that incentivize them to pursue strategic consolidations where they can benefit from those synergies over time.”
Another problem with the returns-driven forced behavior is a stifling of creative juices. “We’ve taken entrepreneurship away from most executive teams. You don’t have to wildcat anymore, but you do have to make your processes better.”
But the number one factor to getting investors back into the space in this commoditized world is fewer participants—and more participants that are able to do it better.
“It’s getting a lot harder to tell the difference between names. Until then, we are going to see a relative disinterest in the broader investment community. Hopefully, we can see that large consolidator come in and pay massive premiums, but in the meantime, some strategic mergers of equals make a lot of sense right now.”
So, who wants to go first?
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