It’s been a rough few years for the oil and gas sector.
At the height of the U.S. shale boom, crude was going for more than $100 per barrel. Expansion and exploration was in full swing across the board, and no project was out of reach!
Unfortunately, the Saudis were petrified about losing market share to developing producers in the U.S., Iran, and even Russia. They crushed oil prices to starve them all out.
This was when we saw prices drop below $30, and the Great Savings Game began.
Since about the end of 2014, the biggest thing on the mind of every oil and gas company has been saving money anywhere it can.
First, it became an efficiency race — a game of who could bring down the cost of operations the fastest?
Then it was all about focus…
Less productive assets were sold off in droves, rigs were shut down en masse, and only the most profitable core acreage were given any attention at all.
Now, we’re finally seeing a recovery on the horizon. It may yet be a slow, painful one, but it’s long overdue. And with that in mind, let’s look at the sector of the fossil fuel market that will be seeing the biggest gains as oil makes its triumphant return.
The Art of Exploration
There are three main sectors in oil and gas:
- Upstream: exploration and production
- Midstream: transportation
- Downstream: refining and marketing
Until now, we’ve been focusing on midstream and downstream companies, as both are still necessary in a glutted market. Upstream investment has suffered since the oil rout, but that’s about to change.
You see, when oil prices dropped dramatically, the smartest companies divested assets that weren’t as productive. These “non-core” areas included those on the outskirts of major U.S. shale basins. Because they weren’t at the core, where the commodities were most readily available, it cost a lot more to keep them producing.
And more than that, it cost a lot more to keep exploring in the area. That alone can cost a company millions, and may not even pay off. Most decided it was for the best, then, to restrict both exploration and production (E&P) to the best of the best.
That has been the saving grace of the country’s strongest oil and gas companies thus far.
Of course, some companies have it better than others, because oil fields were not created equal, with operators in West Texas’ Permian Basin making out better than their sector peers:
(Click to enlarge)
As you can see, both oil and gas production in the Permian have continued to grow.
It all comes down to efficiency.
Technology in the shale space has improved exponentially since 2014, making even old wells once thought empty profitable again. The biggest innovation was the increased, and safer, use of hydraulic fracturing.
This is when a well is drilled, then a mix of water, sand, and chemicals is pumped into it to break up, or fracture, the rock below. This releases more oil and gas, which are then more easily pumped back out.
It’s affordable, it makes the most of every well, and it’s what put the U.S. on the international oil and gas markets.
With every dollar oil gains back, a company is able to bring a handful of wells back online. After months of dropping, we’re beginning to see drilling rig counts go back up.
Now is the time for the E&P sector to make its comeback. Higher prices will directly result in higher revenues, which means companies have more cash on hand to re-ignite their drill programs. And considering the fact that these E&P companies are getting more efficient with each new well they drill, it’s only a matter of time before they turn the taps back on.
5 Things You Must Know Before Buying Oil Stocks
It can be hard now to identify which companies will be bringing home the gold in the next few years. Companies will have to be smart about increasing E&P again, at least until the markets settle down.
We’re not likely to see $100 oil again any time soon. But without a doubt, we will be seeing some major gains in the value of the best companies on the market.
So, how do we figure out which companies those are? Look for some of these qualities…
1. It's not drowning in debt.
In other words, you don’t want to buy a company that has massive short-term debt, either in revolving credit payments or preferred stock payouts. Unless the company has some serious success boosting sales going forward, there’s a good chance you can find your stock in trouble.
Not everyone managed to save money in the current market environment, and nearly everyone had to build up a mountain of debt to keep up their drilling activity… NEARLY.
Most investors don’t realize the monumental amount of new debt E&P companies had to take on since the Summer of 2014, when crude prices started falling. Unless they’re paying into assets that are proven and ready to drill, there’s a high risk on those returns ever coming back.
2. It's exploring in a historically productive area.
When a company does have the money to spend, it should be spending it wisely.
High-risk drilling targets in non-core acreage are still being shelved for a day when oil prices rebound back above $60 per barrel.
Make no mistake, playing it safe now is the way to go, especially if you want to have high hopes that your stock will weather this period of volatility.
Take your time to dig into the company’s operational updates, reports, and presentations. Look closely at where its expenditures are going. Is it exploring within range of its most productive assets? Did it acquire already productive assets from another company?
You’ll also want to be sure that a company spending on E&P is replenishing its production with more reserves. This will also require exploring in areas that actually pay.
If the company is paying for low-grade assets, or losing money on the assets it already has, move on.
3. It's still working to decrease its operational costs.
We’re not out of the woods yet, and any company that claims we are isn’t watching the markets very closely.
Plus, no company should stop innovating for very long. There are always ways to improve costs to keep more money in the bank, even if it requires investing in something now to put the company in a better position later.
Let me make this one clear: this does not mean the company shouldn’t be spending money.
If it is, it should be spending it on asset improvement, cost reduction, and increasing returns.
Look for companies that are spending on research and development, and have a history of decreasing costs such as lease operating expenses, drilling & completion costs, and general & administrative expenses.
4. Its operations are sound and growing.
Don’t let anyone tell you not to take a chance on a great stock. But if it’s a new one, or one that recently had to take a major hit to stay out of bankruptcy, you’d best at least be cautious.
In oil and gas, this means companies with very few operations at all. It may also mean companies operating in areas outside of those already proven to be productive and lucrative. Even if they promise future profits, there’s really no guarantee you’ll ever see them.
What you want to see on their books is steady growth in production, in addition to a lack of major debt and ongoing cost reduction. Look for things like increasing proven reserves, decreased spud-to-completion times, and expanding well lengths.
5. The rest of its balance sheet is consistent and clear.
Companies that hide real results behind flashy news stories or new measurements for income are probably going to those lengths for a reason. Sometimes, it’s not even debt. There are a lot of other factors to consider when looking at a company’s financials.
For instance, if a company’s free cash flow (operating cash flow minus capital expenditures) is low or decreasing, it may not be in any position to pay back debt, even if the debt isn’t very high. That can be a huge red flag for investors.
Others could be traditional investment ratios, such as price-to-earnings (P/E). If this is unusually high or unusually low, it could indicate that the company’s value isn’t in line with its operations or income. With the oil market still in volatile waters, you’ll want to look for a more stable investment to put your hard-earned money into.
These are just a few of the ways to vet a growing — or re-growing — oil and gas E&P company. They’ll get you started on the path to investing in a long-time profit-making market that is more than ready to see the cash finally start flowing back into companies and out to investors.