Defending against a takeover a few months ago may have seemed a worthy cause and the biggest challenge for senior management of upstream companies. Today, a takeover may be the best outcome for many North American E&P companies. The reason is that despite the collapse in oil and gas prices many upstream companies could and perhaps should be acquired or their assets sold. These companies have a negative enterprise value and what asset value they have should be placed into the stewardship of other management teams. That means; asset value exceeds the value of the company.
We examined the publically traded E&P companies operating in North America (US and Canada), excluding the integrated majors. We included only those with $1 Billion or more in market capitalization to ensure scale and resources were not constraints on success. We looked at the 10 year period from 2004-2014, a time frame that includes good times and the recent price collapse. It is also the period encompassing the rise of the shale revolution, a period where strategic vision, strong fundamental processes and talent would play key roles in driving success.
How does one measure success for exploration and production businesses? Some would argue reserve additions and production growth are the right measures. But it begs the question; At what cost? Many veterans who lived through previous price cycles will recall the gut wrenching write downs at year end. The excitement of a new discovery could be followed by a severe hit to earnings if the invested capital exceeds the present value of future production. As a business, E&P is unique in this regard.
While other industries are also capital intensive with high risk, E&P has volatile commodity pricing with very little competitive advantage. Like all businesses, we live and die by the discipline of the markets: capital, commodity, labor, supplies, services and equipment. Among these, the capital markets make the final call about any company’s future. A company’s assets will find the right home with those who can maximize their value. The oil and gas sector is infamous for its waste of capital. For the industry as a whole, it has been longstanding conventional wisdom that the industry does not earn its keep. Our research validates this.
Capital stewardship is at the heart of business success in our industry. There is little to no competitive advantage in upstream oil and gas. All companies have much the same access to the resource base, services, talent, capital and other inputs. Success does not come from a patent, brand name or any other enduring asset. Success comes from the skill of management in allocating and deploying resources.
Another way to view the concept is “Enterprise Value”. The extent to which a company is valued more than the sum of its assets, it has value as an enterprise, a going concern, a business entity. A premium over the market value of the sum of its assets is positive Enterprise Value. A discount or negative enterprise value means the market would rather have another capital steward and the company is ripe for an acquisition or asset liquidation. Does it surprise anyone that oil and gas assets (upstream, midstream and downstream) trade like pieces on a Monopoly board? When the market believes it is time for a change, a company is vulnerable. In reality, management is vulnerable; the higher the executive position, the more vulnerable the individual is to finding a new career opportunity. Activist investors are the catalysts in this asset re-allocation process. To be sure, they are watching and assessing the opportunities. The sheer volume of hedge fund capital that has been amassed to capitalize on the turbulence in the industry is certain evidence of changes to come.
Creating Enterprise Value
Capital allocation is arguably the most important business process in generating assets with a positive Net Present Value (NPV). Efficiently deploying that capital is a close second. Field or Lease Operations is a critical process and depending on the cost chain, the third most important. These processes are measured by the Finding and Development cost, Lifting Cost and Lease Operating Expense metrics. Questions investors are asking , and management should consider are:
The acid test of a capital intensive business is covering its cost of capital over time. Either it earns enough to compensate investors and lenders for risking their money or it does not. There are several ways to look at capital cost coverage: Debt service coverage for lenders, Return on Equity for investors, Excess return to capital for an overall view.
We chose the latter as it provides the most comprehensive picture of capital stewardship. We used the difference between the Weighted Average Cost of Capital (WACC) and returns to capital over the 10 year period ending December 31, 2014. If a company returns a positive difference, the excess return is the reward to providers of capital for taking the risk and making a good decision. We calculated WACC using the Capital Asset Pricing Model (CAPM) which has been the cornerstone of investment practice for decades and is still regarded as the best way to measure risk and return. The benefit of the CAPM is that it incorporates risk into the calculation in a way that a simple total return could not.
It turns out that of the 85 companies analyzed; 15 returned their weighted average cost of capital as displayed Figure 1 below. These are the true “Stars” in that their 10 year average return has exceeded WACC, in some cases by a significant margin. As the metaphor goes, these businesses are “firing on all eight cylinders”. These are also companies that have positive enterprise value, that is, they are worth more than the sum of their assets. The business plans are well conceived and have been well executed. These are cases where the three pillars of People, Strategy and Process are strong and aligned: The strategy is clear and well understood, the business processes effectively support the strategy and the right people are doing the right things.
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There is another group of 33 companies that did not earn their cost of capital, but the shortfall (less than 5%) is not so large that extenuating circumstanced could be at play. For this group, The “Contenders”, success is possible, if not likely. In some cases these companies are undergoing a strategic shift. In others, a management change is in play. But the point is, the directors recognized the need for change and took decisive action. For the first 6 of the Contenders, the miss was less than 100 basis points, almost too close to call and they could well surface as Stars in the future.
There are other members of the Contender group where the strategy is less than it could be, but they are executing well. A review of publically available information shows alignment is suffering. The Exploration Strategy is geographically and/or geologically fragmented. Strategic intent is bland and fuzzy. Lines of communication are long, relying on strong local leadership, a dispersion of talent. Most telling is that the critical business processes: capital allocation and capital deployment are not working well. Managements of some of these companies generally appear to recognize they need better focus. At least they are saying the right words.
In other cases, integration into high performing business units may not have taken place. This could be a leadership (people) issue, faulty communication, teamwork and decision making (process issue), or outside the core competencies of the company (strategy and people issues). Only a deep and thorough evaluation would surface the root causes. But a thorough business review would get at these concerns and identify not only the causes, but the options to remediate them. A commitment by the leadership to a review and fundamental change is crucial if performance is to improve.
The next group of 23 with WACC coverage between negative 5% and 10% is a mixed bag of recognized companies, lesser known mature companies and start-ups. These companies are vulnerable to a variety of events including takeover, a move from an activist investor group or worse. None have established stable profitability, yet for whatever reason, some have garnered favor among equity analysts. Others have been roundly criticized for poor stewardship. Clearly this is a group of mediocre, poor performers that have wasted significant capital over a 10 year period of pretty good times.
These have been followed by a group of 8 that have underperformed by between 10% and 15%. To be clear, this is return on assets that is below cost of capital by a significant margin over a 10 year period of generally rising prices. The best that can be said is that they are struggling. Some of these companies are undergoing turnarounds, some have been made available for sale, yet others, as of publication seem to be barely hanging on. These are clearly poor capital stewards and should see especially tough times during sustained low prices unless they make significant changes.
Finally, we have the bottom of the barrel, the truly troubled companies. They exhibit returns to capital of between negative 15%, exceeding negative 20%. Most of these are clearly chronic capital wasters. The fate of these companies is in doubt. Having failed to return their cost of capital, it is hard to envision they will have the financial resources to weather the storm. Bank loan assessments this fall and asset valuations at year end will perhaps provide some insights. The true test will be in their cash flow and ability to service debt and fixed costs.
However, there is at least one potential success of great significance represented by the last bar in Figure 1. Interestingly, this relatively new startup has achieved some remarkable technical achievements, but it is pre-revenue at this time. In a future post we will focus on this company and its transition from a technical to, hopefully, a commercial success.
This post is far too short to delve into the specifics of each case, but there are some very interesting stories in this analysis. In future posts, we will take a closer look at some of the more interesting cases to see what lessons may be learned. We will look at the obvious successes, the seeming successes, the obvious failures and some promising companies in the making.
 Morningstar calls this economic “Moat”: the strength of a company’s defenses against a competitor.
 Indeed virtually all of an E&P company’s employees have managerial responsibility over some critical part of capital stewardship. If not, why have them there?
 Excerpted and adapted from Todd Wenning in Morningstar Magazine July/August 2015.
 Data was provided from Morningstar, calculations by Pangea Global.