“Nothing Fixes Low Prices Like Low Prices...”

I just returned from the annual OGIS conference in New York where a wide range of U.S. based oil and gas companies presented to the investing public. The event is always an excellent way to gauge the health of the industry and this year proved no exception. A year ago, the upbeat presentations featured colorful maps highlighting the production potential of each company’s reserves. This year, the focus was squarely on balance sheets and financial survival.

A year ago, oil and natural gas prices were already approximately 40% below their 2014 peaks.  Most firms had positioned themselves for a recovery in energy prices by the end of 2015. Instead, weaker than expected demand and stubbornly high supply levels sent oil and gas prices down another 20%-30%. While efforts to hedge commodity price exposure stemmed the damage for some, the vast majority of firms ended the year deep in the red and struggling to stay afloat. For the weaker players this meant restructuring debt, selling off assets and, where possible, renegotiating credit lines. As a testament to the optimism of equity investors, a surprisingly large number continued to raise capital by issuing stock.

Companies across the industry have also responded to the dramatic price declines by innovating. Rig operators are increasing the number of wells each rig can drill and expanding the use of horizontal drilling. As the chart below shows, technological advancements have helped keep production levels high despite the unprecedented 60% decline in rig count. More efficient use of sand and water too are working to reduce most firm’s operating costs from anywhere between 20% and 40%. Research by the Federal Reserve Board economists suggests that breakeven rates (i.e., the rates at which new wells are economically viable) are falling across the industry from an average of $80 a barrel in 2014 to $60, with some fields operating profitably at prices as low as the mid-$20s.

The industry’s new found ability to respond to price changes quickly and a large supply overhang supports the consensus opinion that energy prices will remain “lower for longer.” To prepare for this possibility, companies are continuing to reduce operating costs and capital spending and, where possible, paying down debt. Not all firms have survived the downturn. More than 14 oil and gas firms have already defaulted on debt this year and further bankruptcies across the sector are expected.

In an ironic twist, the industry’s cost saving efforts may prevent a return to the $80 plus price levels witnessed several years ago. As the ongoing decline in rig count suggests, most companies cannot earn an economic profit at current commodity price levels. The current expectation is that new supply and investment will come back on line at the $50-$60 oil level. Natural gas markets, which are generally considered to be more oversupplied, are likely to take longer to bounce back. The advent of new supply, however, will then kick in to limit further price increases.

As last year’s experience proves, getting the exact timing of this rebalancing right is tricky business. Our approach instead is to identify solid companies in beaten down industries that have the wherewithal to withstand a period of weakness. The energy sector remains clearly out of favor today and, as a result, is where we are focusing our efforts.