Following 15 years of massive investment and a multitude of wells proving out the shale concept, the U.S. oil and gas industry has decidedly confirmed that it is unable to consistently generate alpha returns for investors, so said Chuck Yates, former managing director with Kayne Anderson. The reason? In this case beta—the volatility resulting from the price of oil—always and eventually swamps the alpha.

“In energy, as a collective, we have way over sold our ability to consistently generate alpha,” he said, and “we have way underestimated the impact that the beta can actually have on us.”

Yates shared his observations and analysis as part of Hart Energy’s virtual DUG East conference in December.

As a high-level example, he noted that while Chevron Corp. outperformed Exxon Mobil Corp. by 120 basis points, “if you miss the oil price drop of 50%, you lost two-thirds of your money, so beta dominates alpha.

“In terms of looking at energy as a spot to go find alpha, to go find someplace that you can make outsized returns above and beyond what others are doing, it’s just really tough. We’ve just proved as an industry it’s really tough to do.”

The difficulty in generating alpha vs. other peers or sectors lies in the sector’s homogeneity—there are no secrets in the oil patch. New geological discoveries and improvements in technologies are quickly assimilated by other operators. Knowledge from service companies and consultants are shared by all operating companies. And capital, until recently, freely flowed for new ideas.

“So it’s really hard to generate alpha in that scenario. There aren’t many examples we can point to where people are repeatedly generating alpha.”

Contrast the difficulty in gaining an edge to the volatility in oil and gas commodities. Yates said while at Kayne they regularly ran analysis of how often strip pricing was accurate—and the result was always less than 50%, and sometimes as low as 18%.

“Most times a coin flip would have been a better indicator of the future price of oil than the strip. That’s tough to do that as an investor. If you’re going to invest in energy, you need to spend a lot more time on the beta, the oil price, because that is going to so dominate the alpha.”

Ultimately, the oil and gas sector is a low-margin business, he said, similar to a grocery store, working at the margin of commodity prices that track lifting costs. That realization by investors and producers alike is fundamentally changing what makes the energy sector investable.

“There’s really not a lot of reason to drill another well in the United States these days,” he said, as OPEC is poised to backfill the supply gap post COVID-19. “I think we’re going to produce a lot, pay down debt a lot, but not do much in the way of drilling.”

And nickels and pennies are going to matter. “People are going to cut costs. The folks that don’t are going to have tough time, and potentially go out of business. Literally a nickel a barrel can be the difference today between having to declare bankruptcy or not. So, yes, we’re going to have a challenging time, but at the same time, those that are able to execute like Walmart are going to be the ones that make it.”

In this environment, consolidation and automation are necessary for survival, he said, and many more jobs will be lost. “The focus of the industry is going to be producing out as efficiently as possible, and people are costs. We just have too many people in the industry.”

But the flip side of this contraction is that it’s a prime time to be an entrepreneur in the industry, he said.

“Any time there are challenges in an industry like this, there are also great opportunities. Maybe you use your own capital to piece together little projects, maybe you are the person that’s on the forefront of learning how this [new] technology works.”

The age of the driller is over, he said, and the companies that outperform going forward will be valued on different metrics. Instead of watching finding and development costs, now the focus will be measured by lease operating expenses, clean balance sheets and distributing capital back to shareholders.

“Going forward, energy is going to be a low-margin business. It’s a lot of execution.”

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