Fund manager at Sprott Asset Management discusses whether now is the time to buy oil stocks.
[This article originally appeared on Sprott’s Thoughts and is republished here with permission.]
The price of oil appears to be settling into a new price range, leaving oil sector profits at significant risk. Jason Mayer, who manages precious metals and energy funds at Sprott Asset Management LP, is concerned that companies have done minimal budget revisions despite much lower likely profits. We discussed why OPEC was not cutting production, and why the market has been so focused on U.S. shale producers.
What is your response to the new price environment for oil? Are you going out and buying oil stocks, or waiting for things to get worse?
In terms of valuation, a lot of companies are pricing in a significantly higher oil prices than current spot. I am not yet wading back into the space. I do have some core holdings that I’ve continued to hold throughout this downturn. But I continue to be underweight oil stocks.
In the long term: ex-OPEC, only 3% of global proven crude reserves are economic at sub-$70 oil. If you look at this particular price correction, it’s a supply-driven price correction, in contrast with the correction of ’09, which was demand-driven.
If you look at where the vast majority of non-OPEC oil production growth has come from over the last five years, it’s been from the U.S., and it has been driven by the advances in technology and the development of the U.S. shale plays—primarily the Bakken, the Eagle Ford and the Permian. These are higher-cost sources of production.
Another fact is that this huge growth we’ve seen in U.S. production has really been debt-driven, so it has been supplemented by huge loads of debt. And just to keep production flat in these shales, because of their very high decline rates, you have to spend north of $50 billion per year.
To understand the role that debt’s played, I took a look at a cross section of approximately 50 U.S. companies operating in those three shales. From 2012 to 2014, net debt increased just shy of 80%. Over that time too, cash flow was up only 21% and production was up 17%.
So as ludicrous as it sounds, that might be sustainable in a $90-100 price environment, but clearly is not sustainable now.
Just to generate the maintenance capital—the cash flow to keep production flat—assuming a 20% reduction in services costs, you need oil prices of $65 to $80 depending on which particular shale we’re referencing. So the question is, when will we see supply decrease?
The answer is that I don’t know. I know that the supply response is really going to be a function of price—how low prices go and how long they stay there. In other words, it depends on how painful it is for the companies.
This is going to be a market-forced correction, and we’re starting to see some of the budgets coming out of these companies. For the most part, from what I’ve seen, the budgets are still a little delusional. Most are using higher oil prices than we have now.
I want to see the more draconian budgets come, where you’re seeing declining production, companies batten down the hatches, and really focus on preserving the integrity of their balance sheets.