Investors beware -- the energy industry is about to go through a massive, Darwinian cleansing period.
Over the past few months, I've sifted through dozens of energy-company financial reports and investor presentations. My research has focused on what I view as the better players, as I often rely on top investors' energy picks to screen my way through the hundreds of companies out there.
Generally speaking, I've begun to see some commonalities among energy companies.
First (and unsurprisingly), virtually all energy companies are cutting back on 2016 capital-spending plans. In some cases, cap-ex will be down as much as 50% or more year over year.
Another commonality is that despite cap-ex reductions, production volumes are likely to increase -- in some cases significantly. This paradigm shift of reduced spending and increased production is going to create a Darwinian effect on the oil patch.
The Financial Times had an interesting article over the weekend that said U.S. shale producers had $30 billion of cash outflows during 2015's first six months. Capital expenditures exceeded cash flow from operations by $32 billion during the period, while U.S. Energy Information Administration figures showed that overall U.S. oil production fell during May and June.
Perhaps more striking, the article noted that debt levels on U.S. shale producers' balance sheets have more than doubled to $169 billion today from just $81 billion in 2010. Access to capital has led U.S. energy players to drill relentlessly, but that party won't last forever -- and when it ends, it will become a survival-of-the-fittest contest.
As is typical, many energy companies will have to revalue their "borrowing bases" -- the valuation of their oil and gas reserves, which banks use when deciding how much credit to extend -- come October. Given the significant asset writedowns they've had to take in light of today's low energy prices, those firms with unsustainable leverage levels could experience a major restriction in capital availability.
Companies unable to "right-size" their businesses will either go under or get taken over by stronger players at discounts. Production levels will then start to decline and the industry will begin the painful process of recalibrating itself for today's "new normal" in energy prices (whatever that might be).
The takeaway here is that very patient investors who choose carefully and are willing to handle volatility can find some bargains in the oil patch. But if that's not you, don't try to catch a falling a knife by convincing yourself that energy companies' prices can't go any lower.
Equity prices can always go lower until they reach zero. And in the current oil-market environment, I suspect more of that will happen in the coming months.