It is pretty clear there is a wide divergence in performance among the largest North American oil and gas production companies. At mid-year 2015 we did a study on the largest players, those that at time had a market capitalization (total value of equity) greater than $1 Billion. That screen resulted in approximately 90 companies engaged in exploration and production in the US and Canada. The study illustrated in pretty stark terms that during the 10 year period 2004-14 only a few companies met the number one performance criterion, Return on Invested Capital (ROIC). Further, this was the boom period culminating in oil prices over $100 per barrel. If a company were to succeed, this would be it, yet only a few did.
One year later, it seems sensible to take another look to see how the Stars, Contenders, Vulnerable, Struggling and Troubled companies had performed during the downturn. To say the least, the performance was pretty miserable. During their latest Fiscal Year, not a single upstream company had earned its Weighted Average Cost of Capital (WACC). No surprise there. That period, nominally 2015, saw an unprecedented fall in oil, and to a lesser extent, natural gas prices.
An important question is: “How well have the players managed and which are poised to survive and thrive?” Let’s first take a look at the categories. In the graphs below we see the ROIC Premium over WACC, for the categories. The left graph shows the 2004-14 period, the right for 2005-15.
In summary, after only one year of low prices:
One company fell from Star status to Troubled and one fell to Vulnerable. The rest of those that lost their Star status (9) fell back to the Contender category. An almost equal number fell from Contender to Vulnerable and from Vulnerable to Struggling. It is surprising that just one year would create such significant shifts.
Taking a deeper look at relative performance, more detail along with the underlying causes for the differences begin to emerge. The following graph shows how the five categories performed in their Return on Assets (ROA) for each of their last 10 fiscal years 2005-15.
The better performing groups, the Stars and Contenders not only performed better on average, they performed better in each year. There is a decided downward trend for all groups, but large differences are clear. The Contenders appear to have been gaining ground relative to the Stars until the collapse in prices widened the gap. The Stars did better managing the price collapse, falling less than the others.
The Struggling suffered wide fluctuations in performance and never gained traction as prices peaked in 2013-15. One could judge that these companies along with the Troubled were caught in the bind of rising cost of services and supplies that overran rising product prices. In essence they were caught in the trap of trading dollars between their customers and suppliers, not capturing much for themselves. The Vulnerable seemed to have gained some price v. cost advantage from FY4 to FY2 (roughly 2012-14) but suffered the same precipitous fall as the other two underperforming categories: Troubled and Struggling.
A major consideration of investors is risk. Normally, standard deviation is the primary measure. Standard deviation is simply a measure of variance about the mean (average) return. Observing ROA performance, it appears there is a significant difference in variation among the five categories. The next graph is a comparison of the ROA standard deviation for the five categories.
The differences are pretty stark in that the Troubled companies have over 3 times the risk of the Stars, while the Struggling are over twice as risky. A prudent investor requires a premium for this additional risk, but the three under-performing categories generated no premium and in fact turned in pretty disappointing results.
Delving deeper, the following graph compares the operating margin for the five categories along with the bench mark product price, West Texas Intermediate, monthly average.
The differences confirm that the two lowest performing categories could not keep costs in line with revenue and were dramatically exposed to fluctuating oil prices. Even with prices consistently above $80, these companies simply could not generate a positive margin. Since all 90 companies had basically the same commodity market the big difference is in the way they could hedge forward production, or more importantly, how effectively they controlled cost. Of particular note, is how the Struggling and Troubled companies’ margins went into free fall when prices fell steeply at the start of the recession. However, there seems to have been some learning that caused them to better sustain their margins in 2015. From personal experience, there is a tendency toward hubris when prices are high and production is growing. The term “Touch of Midas” recalls the mind set during an earlier boom period. It is very clear that cost control eluded the poor performers, while those that focused with discipline on ROIC barely noticed the first price collapse and sustained margins more recently.
It should be noted that some of the performance challenges for the two lower performing categories are the “Start Up Effect”. That is one company pulled the average for the Struggling group down during its first year of operation. Nevertheless, the lesson remains valid that operating discipline is a key performance driver.
With a basic understanding of the performance differences and a sense of where those differences come from, the next step will be to dive deeper into the drivers of the Operating Margins. In future blog posts we will get into those factors in greater detail.