A recent article in the Wall Street Journal reports that energy hedge funds are under pressure from institutional investors. These mainly pension funds along with college endowments face tens of billions in losses from their investment in the Exploration & Production (E&P) sector following the fall in prices. After prices plummeted at the end of 2014, private equity rushed in armed with over $60 Billion of new investor money. Another $30 Billion has gone in so far in 2016. Private equity has been successful attracting new investment since the downturn on the basis of a “contrarian” play. That is, when prices return to normal, the new money will reap a windfall. That has, so far, not been the case. Yet, is there hope for the institutions and their beneficiaries?
Since the price of oil went into free fall at the end of 2014, nearly $60 Billion of market value has evaporated from the top 90 North American E&P companies. The average is approximately $600 or a little under 10%. That is certainly not a total collapse. Of those companies, 35 have increased their market value while 55 have lost value. In light of the fall in oil prices (WTI is down from its monthly peak of $106.57/barrel in August, 2013 to $44.72 in August 2016, a decline of 58%. On the surface that suggests the sector has sustained market value reasonably well. (click on link below)
A deeper examination suggests all is not well. All 90 companies in the study group currently trade at a premium to their fair value. Fair Value is the net present value of future cash flows accruing to equity holders. For the oil and gas production companies that means the aggregate cash flow from their properties is worth less than the companies are valued on the stock market. That is the classic example of a bubble. Since production companies are a collection of assets, the underlying assets are valued less than the companies.
All this suggests the woes of private equity firms and their institutional investors are far from over. Some of the more cautious, one might say prudent, private equity players have been buying the debt of distressed production companies at steep discounts. The theory is that in bankruptcy, the equity will be wiped out and the debt holders will acquire the company for the value of the debt. In essence, this is a debt for equity exchange. Then the question becomes “Is the fair value of the assets greater than the value of the debt?” There are 51 companies with a Fair Value Premium over Debt. Of those 33 have a Fair Value to Debt ratio greater than 2:1. That is, Fair Value could be overstated by 100% and the debt holder/owners could come out whole. Some consolation for the new money, not so good for the old.
There are some real bargains in the form of quality companies that delivered a premium over their cost of capital during the boom period 2004-14. These are the Stars as documented in our white paper on Capital Stewardship. These are companies that, even though they sell at a premium to Fair Value and are likely to fall in value with a collapsing bubble, will be survivors long term. Some may even learn how to prosper. However, none of the North American upstream has returned its cost of capital in the last fiscal year. That means none have figured out how to thrive in the new normal.
Our view is that the reason for this situation has several components.
First, the economy is awash in liquidity from the Federal Reserve Board’s Quantitative Easing (QE) used to prop up the economy. The resulting low interest rates and low investor yields has sent investors on the hunt for yield. The private equity funds have been more than willing to guide those hunting trips, but it has taken investors into risky territory. The liquidity continues to flow and the contrarian story has not stopped playing despite evidence that it may never pay off. How long will that last? Interest rate forecasts are chronically optimistic and have been notoriously wrong for the better part of a decade. The Fed would dearly love to begin raising rates, but the US and global economies are so fragile that only small widely spaced interest rate increases are likely.
Second, shale development is a disruptive technology that has shaken the upstream to its core. Oil supply has suddenly become unconstrained as the resource base can easily be converted to reserves and in turn production. The cost of adding new reserves continues to fall and the risk of failure has dropped significantly. A dry hole is virtually unheard of in the shale plays. Thus the risk reward tradeoff has been changed. It is difficult to imagine a scenario where supply once again becomes a constraint. The known shale resource base is already so vast globally and it continues to expand as more development takes place. Most of this development has been in the US and to a lesser extent in Canada. But other countries are experiencing activity, such as Argentina and more would love to follow suit.
Third, OPEC in general and Saudi Arabia in particular have unleashed a war for market share that shows no sign of ending and no discernible end game. The Saudi’s sought to drive the shale producers to ruin, but their ability to respond with lower costs has shown that strategy’s Achilles heel. How long can the Saudi’s continue to play beggar-thy-neighbor? There are a lot of moving parts to that question, including their hard currency reserves and their population’s tolerance for reduced social spending and subsidies. But one can make the case it is a few years at best.
It is probably safe and prudent to say that nothing lasts forever. But the changes set in motion have really only just begun. Thus, rising prices are not likely to be the salvation of the private equity firms and their institutional investors. What is at question is when will investors and investment managers realize that we are in a new normal and not a contrarian play?