I had the opportunity to attend EnerCom's Oil & Gas Conference in London this week. It was a terrific job by EnerCom's Greg Barnett and crew, as the conference reflected an eclectic mix of global energy players. Here are my key takeaways.
Hot shale plays need to be exploited quickly, despite historically low gas prices. Several participants noted the largest problem facing shale drilling is high decline rates. Wells deplete quickly as the oil and gas are fracked out of the shale, so first-mover advantage is key.
That said, rig counts continue to decline from 18-year lows in the U.S. as historically low natural gas prices dampen incentives for production. So, producers are sitting on wells instead of maximizing production, but "hot" shale plays continue to attract new market entrants. Production isn't going to decline, it's just a matter of who will produce it. Ideally, a company would be exploiting now and accepting lower IRR (internal rate of return), but still generating cash flow.
My view is that financing markets are entering a much less attractive phase. High-yield-bond prices are falling and the equity markets have peaked. Thus, the well-run exploration-and-production company would have raised capital in the last nine months and would be deploying it now.
High production at lower prices combined with rapid decline rates doesn't support higher equity values, but strong production supports cash flow and the ability to make interest payments. That's why our strategy at Portfolio Guru LLC is to invest primarily in bonds and preferred shares of energy companies, not the common. Stocks may be attractive in special situations like Gastar Exploration's (GST) legal issues or Magnum Hunter Resources' (MHR) accounting issues, but, generally, this is a sector for fixed-income investors, not stock-pickers.
Getting gas to market in new ways will be key for producers. Range Resources (RRC) is a major player in the Marcellus Shale, and management remains bullish on the production potential of its southwest Pennsylvania assets. The outlook on natural gas pricing was much less optimistic, though, as there is opportunity for industrial users to shift to coal, which, in management's view will stop natural gas prices from re-attaining $5.
So, Range is focused on getting their abundant supplies of gas to new sources. Coal vs. Gas is not the only competition in industrial world, and Range is exploiting a pipeline from western Pennsylvania to Ontario, where it is supplying chemical plants with ethane, a nat gas-derivative, which is a cheaper "cracking" feedstock than oil-based naphtha. Also, Range is piping ethane to the port of Philadelphia, where it is being loaded onto ships bound for Norway.
Nat gas prices in Europe are 3x the price in U.S., and well-run companies will exploit that arbitrage.
While it is debatable whether the U.S. has an energy policy, China clearly has one -- and it's effective. Two of the presentations, by ERHC Energy and Petrobras (PBR), featured non-U.S. entities and China is important for both. ERHC is a microcap company with holdings in Kenya and interests in fields in Chad and off Africa's west coast. Sinopec is a competitor, supplier and partner to ERHC and management noted how effective they are as an organization.
Similarly, Petrobras has turned to Chinese shipyards for help as Brazil's shipbuilding industry has been unable to provide timely deliveries of floating production, storage and offloading (FPSO) units to exploit Brazil's massive offshore oil discoveries. While local content is an important issue, when times are desperate they turn to the Chinese.
So, global stock markets may gyrate on short-term economic reports out of China, but its government-sponsored entities' capital plans are persistent. Oil exploration has a long lead-time, and investment stability is a key competitive advantage for Chinese industry.