Sink or Swim?
Three things to look for when deciding which energy companies are worth your dollar
WE ARE NOW ONE AND A HALF YEARS
into what is no doubt a full-fledged commodity crisis and it is looking likely that this will be one of those dreaded lowerfor-longer periods. The global commodity complex was vastly over capitalized resulting in a massive supply glut that will take some time yet to work through, while global demand growth is slowing.
This is not good news for oil and gas companies, which tend to be reactive rather than proactive and are only just now starting to take the necessary steps to ensure they are able to survive any prolonged period of low oil and gas prices.
It is akin to the reality TV show Survivor whereby contestants do everything in their power to make it to the next round. The problem is that it may be already too late for many of the oil and gas castaways that are on the verge of getting voted off of the island.
Investors, therefore, have to exercise extreme prejudice when investing in the sector. To help, there are three key factors investors need to look at when deciding which companies will be able to survive until prices eventually recover.
Beware of the yield trap
Investors can get sucked in by high dividend yields, otherwise known as the yield trap. One can’t blame them as these double-digit yields can be very enticing especially in this ultra-low interest rate environment. But a high yield is often a warning sign that something isn’t right. For example, at the start of the year the TSX-listed oil and gas companies with the largest dividends had an average dividend yield of 11.4 per cent. Investors in these companies saw their share prices collapse an average of 42 per cent since then compared to the S&P TSX Capped Energy Index, which was down only 17 per cent over the same period.
Debt works both ways
Companies with high debt loads can be enticing during periods of strong oil or natural gas prices, because they are essentially leveraging their exposure to the commodity. During the good times those companies will generally have a debt-tocash-flow multiple of two times or more, which doesn’t look too bad – at least until commodity prices start to correct.
While on the surface their total enterprise value remains somewhat flat, debt quickly takes over the market capitalization, leaving little in the end for shareholders. We calculate that those companies with a higher debt load have seen their share price fall by a whopping 60 per cent this year, with more downside ahead.
High cost producers pose the greatest risk
Companies with high and inefficient cost structures will not be able to weather the storm. And it wouldn’t be unusual to see some of these companies soon turn cashflow negative should oil and natural gas prices fall further.
Unfortunately, many of these poorly run companies do not undertake any sort of meaningful hedging or risk management programs that are now proving to be lifelines for those that were prudent enough to undertake them. It’s also wise for those investing in the sector to run their own simulation, and stress test a company to see how long it can last under its current cost structure, and then estimate under which scenario it starts to get into serious trouble. One needs to do a bit of homework first to find the corporate decline rate, the previous capital efficiencies, and the overall cost structure and net backs. While there is likely more pain on the immediate horizon, we still believe the current environment offers some excellent value opportunities.