Guest contributor Michael Corcoran joins us this week with his thoughts on some of the recent headline stories in the turbulent energy sector. Michael is a Chartered Financial Analyst with seventeen years of experience in the financial industry, both in Canada and the U.S. He is now an independent consultant who researches and markets investment ideas. He is based in New York City. Here is his report.
Michael Corcoran writes:
Whenever we hit an economic crisis – and the energy sector is certainly experiencing one now – you can depend on the media to come up with a deluge of stories that will shock, scare, or stimulate you, depending on your perspective. It’s no different this time. So to keep matters in perspective,
I’ve taken close look at a couple of recent Bloomberg articles that received a lot of attention. Here are my thoughts on how you should think about the points they raised.
“The Price of Oil Is About to Blow a Hole in Corporate Accounting”
- Bloomberg, March 3, 2015
Well, that certainly caught my attention! The article then states that: “There’s one place in the world where oil is still $95 a barrel. On paper.”
Oh, this was getting more and more interesting! The article goes on to talk about two different accounting items. The first is the valuation of oil reserves in financial statements. The second is the present value of estimated future cash flows to be realized from those reserves. Hmm, dull stuff.
However, the interesting thing is that both items use the average price from the first trading day in each of the last 12 months. Now, oil prices didn’t start their nosedive until late November so we’ve only had significantly lower prices for the last four months. The article notes that the impact of these lower prices is starting to be felt on oil producers’ balance sheets – an impact that will be revealed when companies start reporting first-quarter earnings this month.
So you might be asking yourself: Are we going to see a flood of oil producers writing down their reserves and the present value of their estimated future cash flows when they release earnings in the coming weeks? The answer is yes. The next question you might ask is: Are the stock prices of those oil companies going to get whacked as a result? In this case, the answer is no. The flood is coming but oil stocks should be able to continue bobbing merrily along. Now you might be saying to yourself: Huh?
The reason for this is provided within the article itself, which quotes Global Hunter Securities analyst Mike Hunt as saying: “What the SEC requires isn’t thorough enough to get to the numbers investors really want…what is the true cost of producing a barrel of oil? And what is the real value of the assets?”
As far as the reserve calculation goes, this number tells investors what reserves the company could profitably produce at that historical average price. That’s useful to know as a starting point when you are trying to estimate an oil company’s value but the problem is that number does not provide enough detail to determine the real value of the assets. The reserve calculation that is disclosed gives investors a rough idea of the size of economical reserves and they will monitor reserve additions – which are usually also disclosed if they are sizeable. But investors are not holding their breath waiting for the latest estimates. The only thing they would freak out about is if the latest valuation showed a surprisingly smaller amount of reserves that could be profitably produced. This is possible because reserves are added and depleted on an ongoing basis but usually not in amounts that should be significant enough to move the needle.
Something investors do focus on in regard to reserve valuation is a company’s debt level. Reserves are often used as collateral against bank debt and when oil prices are dropping, the value of that collateral drops as well and the company may have to post more as a result. The thing is, investors react to this in real time. As oil prices dropped, the stock prices of those companies whose reserve valuations and debt levels were of concern got hit. This is not to say that these investors know exactly what a given company is worth but it does mean that they have already anticipated and reacted to the issue of a revaluation of reserves. So, at this point, the release of the company’s reserve valuation should be a non-event.
As far as the present value of estimated cash flows goes, analysts already have their own estimates for future cash flows that incorporate their own forecasts of future oil prices – they don’t need an estimate based on historical prices. The analysts’ oil price forecast incorporates recent price movements so the company’s estimates are too little, too late.
Once again, the market responds in real time to significant changes in oil prices. As prices dropped, investors’ estimates of future cash flows dropped as well and stock prices declined as a result. The estimate provided by the company is helpful but the number that would really be useful would be the company’s true cost of producing a barrel of oil. But they do not usually offer that for “competitive reasons”.
We can see proof of the “non-news” of these numbers by looking at one of the examples provided in the article: Continental Resources (NYSE: CLR). The article notes that in a Feb. 3 press release, CLR stated that its reserves were worth $22.8 billion but goes on to say: “Three weeks later, Continental published more detail in its annual financial report to the SEC. Using current prices instead of the SEC-prescribed $95 a barrel would erase $13.8 billion, or 61%, from the value of Continental’s oil and natural gas properties. It would also mean that 10% of the company’s reserves, the equivalent of 135 million barrels, would be too expensive to pump with prices where they are.”
Now 61% is a whopper of a write-down! And 10% of the reserves are no longer economical at current prices! Man, I bet the stock got clocked! So what happened to CLR’s stock price? Hmm. Pretty much nothing. The date of the press release was Sunday, Feb. 22. On Monday, Feb. 23, CLR’s stock dropped just over 1%.
That’s kind of crazy, isn’t it? Well, it is and it isn’t. As noted above, the information investors would really like to know is the true cost of producing a barrel of oil and the real value of the assets. Neither the reserve valuation nor the present value of future cash flows gives us that. So while it’s nice information to have, it’s not that illuminating when it comes to valuing the company. Hence, it gets discounted or just plain ignored.
So, in the coming weeks, if you see a hurricane of headlines that say so-and-so company has written down their reserves by 20% or their present value of their future cash flows by 50%, don’t run for shelter. The “news” storm shall pass and the sun will soon shine again.
This touches on a larger question relating to accounting write-downs and stock market behavior, or lack thereof. We often see headlines that shout about large write-downs but we don’t see much, if any, impact on the stock price. Why is that? These are often big numbers and you would think there would be some repercussions. Someone has to pay! This is accounting after all. We’re talking about a company’s report card and a write-down is an F, isn’t it? Well…no.
There are two main reasons investors will often “ignore” this information. The first is that it is historical – it’s already happened. It’s not relevant to the future so they don’t care. The other reason is that some accounting items are only of interest to accountants. As we saw with the example above, the SEC requires companies to disclose information with the goal of giving investors a more informed picture of a company’s assets. That’s a great idea but in practice it does not always succeed. As a result, what might seem to be very important information actually isn’t.
“Here’s How $20 Oil Could Become a Reality If Storage Runs Out.” -Bloomberg, March 24, 2015
Whoa! More bad news for oil! This article discusses the fact that U.S. oil stockpiles are at record levels and notes we’re coming up to refinery maintenance season, which results in reduced demand and potentially more oil headed to storage as a result. The article then imagines that if there was a problem with other refineries, demand for oil might drop drastically, oil storage might fill up, and then we could see oil prices nosedive to $20 or less! So is this possible? The answer is yes. But is it likely? And the answer to this is found in the article itself when they say: “That’s probably not going to happen.”
Here’s why, again quoting the article: “If 2015 follows an average year of refinery maintenance, the current glut should never be more than a nuisance. But if 2015 matches up with the worst period in a decade, there will be trouble in the two biggest storage regions: Cushing, Oklahoma, and the U.S. Gulf Coast.”
So, the $20 oil doomsday scenario requires an extreme season of refinery maintenance. That is a possibility but not a real threat at this point. We could also see the conflict in Yemen spread across borders in the Middle East. If it did, oil prices would skyrocket – at least in the near term. Is it likely to happen? Not at this point but I would place a higher likelihood on the Yemeni conflict spreading than for the U.S. refinery maintenance season to be in-line with the worst in the past decade.
Even if there was a problem with refinery demand for oil, there are three factors that would quickly respond to this: imports, production, and offshore storage. In the event of U.S. oil storage capacity reaching its limits, U.S. oil imports would immediately drop – there wouldn’t be anywhere to put the oil. Second, shale oil production can, and would, be dialed back quickly. And finally, there is an additional source of storage to be had and it’s only a little more expensive than land storage: floating storage. The oil tankers that shuttle oil cargos around the world can, and are, used as floating storage when needed. So were the doomsday scenario to unfold, oil prices would probably fall but the drop would be relatively short-lived. The market would respond and would redirect the oil to other places where demand was greater.
When it comes to oil prices, there are tons of possible scenarios that could have a dramatic impact either positive or negative. It’s good to have an idea of what these scenarios are but it’s also important to realize that you cannot anticipate all of them and many would be short-term events. Keep that in mind the next time you see a news headline foretelling another doomsday scenario for oil prices.
Finally, there has been a lot of media focus on what might happen in the oil market as a result of the tentative deal over Iran’s nuclear facilities. A series of Bloomberg stories in late March noted that Iran may be hoarding anywhere from seven to 35 million barrels of oil – supply that might hit the already oversupplied market in a hurry if sanctions are lifted. In addition, the Iranian oil minister has said that they could increase oil exports by one million barrels a day within a few months.
Iranian exports are currently around a million barrels a day, down from 2.5 million before the sanctions were imposed in mid-2012. So we’re talking about a potential short-term increase in supply from the Iranian oil in storage plus a significant bump from increased exports on an ongoing basis, neither of which bodes well for oil prices.
However, keep in mind that the actual size of the oil hoard is unknown. Although it is probably a large amount, the market would quickly absorb it as it represents, at worst, less than one-third of a day of global demand. If the market was flooded with this hoard all at once, the oil price would likely drop, but it would quickly bounce back provided there were no additional amounts of oil being sold. It’s also possible that Iran might continue to hold on to the oil and wait for higher prices before selling.
The real cause for concern is the potential increase in oil exports by one million barrels per day. An agreement that allows for unfettered Iranian oil exports would be very negative for prices. How negative will be determined by the speed and the size of export increases – the smaller and slower, the better.
The silver lining here is the time frame. Analysts believe it may take anywhere from six months to a year before Iran can increase exports by that amount. The reason for this is that it takes time to ramp up production at conventional oil fields – it’s not like turning on a tap. And Iranian oil infrastructure is old and desperately in need of investment, which further restricts the speed with which they can increase production and exports. However, given that the market is a forward-looking machine, that time frame will quickly be reflected in oil prices and will place further pressure on high-cost producers, in particular North American shale oil producers.
Given the decades of enmity and distrust between the U.S. and Iran, any binding agreement achieved would be nothing short of miraculous. The negotiators have until the end of June to reach a final framework based on the principles agreed on in Geneva. If they do arrive at an agreement, it is very likely to specify a gradual, phased-in process that dictates sanctions will be lifted in stages upon Iran meeting certain milestones, with the threat of immediate re-imposition for any violations.
If this is what comes to pass, the impact on oil market will be mildly negative but the news will probably be positively received, as the worst will have been avoided. And given the likely gradual lifting of sanctions, the oil market will have time to adjust to the steady increase in supply. At this point, only time will tell.
So the next time you see a headline shouting about massive write-downs or an article that portends ominous developments, ask yourself this question: How does this news affect the current, and, more importantly, future operations of my company? If you think about this, you will often find that what is considered “news” is often just “noise.” The media makes a fair bit of noise on a daily basis – the better to get your attention – so find yourself a good set of earplugs and tune it out whenever possible.
ExxonMobil (NYSE: XOM)
Originally recommended on Jan. 5/15 (#21501) at $92.83. Closed Thursday at $84.30 (All prices in U.S. dollars.)
XOM reported better than expected fourth-quarter results on Feb 2. Earnings were $6.6 billion (down 21% year-over-year). That worked out to $1.56 per share compared to the consensus estimate of $1.32-$1.35. The results had a number of special items which, when excluded, resulted in operating earnings of about $1.46-$1.47 per share. The decline in earnings is the result of lower oil prices.
Upstream results of $5.5 billion (down $1.3 billion year-over-year) were solid. Production was 4.054 million barrels of oil equivalent per day (boe/d), down 0.7% year-over-year. E&P profitability was $12/boe, down from $18.2/boe in the third quarter and $17.5/boe in the fourth quarter of 2013.
Downstream results of $497 million (down $419 million year-over-year) were disappointing but this was mainly due to an inventory charge for refining that resulted from a timing lag that had a negative impact of $600 million. Essentially, the refineries were processing previously purchased high cost oil, an effect that should disappear going forward.
XOM distributed $5.9 billion to shareholders in the fourth quarter, including $3 billion in share buybacks. Dividends of $0.69 increased 9.5% compared to the previous year. Dividends per share are up 55% since 2010 and the company has distributed $0.46 of every dollar generated between 2010 and 2014.
Operating cash flow before changes in working capital and gains from disposal of assets was $11.1 billion and covered capital expenditures (capex) of $10.5 billion. Assuming $50-$58 oil, operating cash flow will cover capex going forward but not dividends. The dividend is completely safe as any shortfall in cash flow will made up for with debt. Dividend coverage should resume in 2016, as capex is lowered and operating cash flow increases with expected higher prices.
The big news was that the size of the planned share buybacks has been decreased to $1 billion per quarter from $3 billion previously. Given lower oil prices, this move did not come as a surprise but it is a negative as it decreases what has been a solid support for the share price. The new buyback level and current dividend provides a return of capital of about 4%. If and when oil prices increase, the size of the buyback will likely be increased to previous levels.
On March 4, XOM held its annual analyst day and the main news was that it updated its capex budget. As expected, the budget was cut to $34 billion in 2015, down from a previously projected $37 billion. Despite the cut, production targets of 4.1 million boe/d in 2015, 4.2 million boe/d in 2016, and 4.3 million boe/d in 2017 (assuming $55 Brent) were maintained. This indicates the company expects to achieve increased efficiencies and productivity, which is a strong positive. XOM is coming off an intensive capital spending cycle and going forward capital spending should continue to decrease, giving it greater financial flexibility than its peers.
Action now: Buy. XOM is best positioned among the majors to weather the downturn in oil prices given the size of its cash flows compared to its spending targets.
- end Michael Corcoran
