The term I heard the most during the three days of the Independent Petroleum Association of America's OGIS conference was "outspend." Put simply, capital expenditures exceed operating cash flows, which in the energy business are usually represented by EBITDAX (earnings before interest, taxes, depreciation, depletion, amortization and exploration expenses). I couldn't even count how many managements noted that 2014 capital budgets would exceed cash flows.
That doesn't mean these managements are burning money. Rather, they see more opportunities than they can self-fund. What first attracted me to this industry and especially to the smaller companies is the absolute level of capital discipline that these management teams exercise.
Any energy CEO can tell you point-blank, "This is what a well costs us, this is our lifetime production in barrels of oil (EUR -- estimated ultimate recovery -- in industry parlance)," and those tools make calculating the internal rate of return of a well quite simple. With a decade of sell-side analysis of auto companies in my past, trust me when I say that in other industries, most CEOs have almost zero grasp of such figures.
The takeaway is that opportunities are greater than originally anticipated. Remember that unconventional shale drilling techniques have really only been around since 2003, and the huge boom has occurred in the last five years. So there is a learning curve here, and make no mistake, the fact that so many managements want to spend so much is a wildly bullish indicator.
But obviously, capital is scarce, and if the capital budget calls for $100 million and the cash flow is $50 million, that capital is going to have to come from other sources.
The taxonomy of capital-raising is really driven by company size and "seasoning." Younger companies that have high production growth will seek a "mezz piece." This is usually a privately placed preferred-share issue (in the mezzanine portion of the capital structure between debt and equity, hence "mezz") which often comes with warrants attached. More established companies will issue exchange-listed preferreds (the core of our holdings at Portfolio Guru). The "graduation" from junior status is usually indicated by the issuance of senior debt, usually in the high-yield category. The ultimate step-out is into bank-provided revolving credit facilities, which are based on levels of proven reserves.
From a stock-picking perspective, maturity is not necessarily the optimal situation. It may seem counterintuitive, but identifying attractive equity plays can often be done by seeking out companies that are raising the "riskiest" capital. Early-stage companies offer the highest potential returns, and thus when I see a company raising a mezz piece, my antennae rise, while the use of primarily reserve-based financing makes me think that company may be too mature to have massive upside left in its equity. The key word here is "use." Many companies procure revolving financing capability as a backstop, then never actually use it.
An interesting pair of examples from my portfolios would be Torchlight Energy (TRCH) and Gastar Exploration (GST). Both managements presented at OGIS. These two companies participate in the same play (Hunton Limestone in Oklahoma) with the same partner (Husky Ventures), but the difference in life-stage is clear. Torchlight's management is relentlessly raising capital from friends and family and is in the market for a mezz piece. Gastar has senior notes outstanding, two preferred issues and plenty of room in its reserve-based revolving credit facility. So when choosing stocks for Portfolio Guru's "Mad Money" portfolios, choosing Torchlight over Gastar was a matter of choosing the upside of youth, rather than the soothing stability of steady cash flows.
Note also that for my classic income-based portfolios, the opposite applies. I have been buying Gastar's preferred series for my clients for the last two years and plan to continue doing so for the foreseeable future. I believe Gastar is a terrific credit investment, and my clients and I have enjoyed watching the market gradually realize that the interest rate demanded for Gastar's preferreds is too high for a company that can produce steady cash flows.