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On the outlook for the gas and oil industry

Published on:
August 31, 2019
Last Update:

Written by

Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

The gas and oil industry is not for the faint of heart. The S&P Oil and Gas Equipment services halved this year and is down 80% compared to five years ago. And from the macro to the micro: Noble Corporation (NE on Nyse), whose price is now less than two dollars a share, traded for $28 per share in five years ago. Gulfport Energy (GPOR on Nasdaq), which I bought a few months ago, now trades at $3 compared to $60 five years ago. At least the two firms are still in business. Atwood Oceanics, Inc., Hercules Offshore, Inc. and Paragon Offshore PLC - all filed for bankruptcy protection.

It is a cyclical business per se. In The Investment Checklist , Michael Shearn writes that "certain industries operate independently of the economic cycle. In such case, the product or service may be more of a necessity." He lists tobacco companies, pipelines carrying oil and gas and student housing REITs as examples. And as the U.S. economy continues to expand (the longest expansion recorded), the oil and gas industry contracts. What goes down must go up?      

To answer, we should first look at the demand variables. I refer the reader to page 12 of the NE's 10-K report for example, where management discusses 25 factors that affect the price of oil and gas and the level of activity in offshore exploration.

To name just a few of the factors: the level of production in non-OPEC countries, merger and divestiture activity among oil and gas products, the political environment of oil-producing regions (including uncertainty or instability resulting from civil disorder) and the discovery rate of new oil and gas reserves either onshore or offshore.

In short, to foresee where the oil and gas industries are heading is to prognosticate.

The gas and oil industry is depressed because the price of crude oil is down and because oil supply exceeds demand. Is it temporary? 

So instead let us name a few of the current reasons why the industry and its shareholders are depressed. First is the price of oil. Five years ago a barrel of WTI Crude Oil[1] cost over $90. It is now about $55. And not unlike the gold rush, if commodity price is down, no one tries to dig it out of the ground.

WTI average price since 1969
WTI's 10-year average price since 1969

The second reason is that daily crude oil production increased to four million from one and half million barrels. So, the demand of service from offshore fields, which are more expensive, declined.

The third reason is the demand and supply equation. There are simply too many rig suppliers and too little demand for them.

Yet I think the imbalance is temporary. Visit the Macrotrend website to see that over the past decade, the price of oil moved - and at times, frantically up and down - but upwards was the overall trend. Or instead of staring at the computer screen, you can just ask anyone older than sixty-five if gas prices were cheaper or more expensive when they were thirty.

Noble Energy  

So I speculate that the price of oil will rise again and that the price of gas and oil companies will eventually follow. I made this bet by buying a few shares in Noble Energy.

While Noble is now fraught with many risks (to name a few: the company is being sued; it is burning cash flow and the leverage ratio[2] and interest expense ratio are higher than ever before), I focused most of the reading about the company before the gas and oil industry turned sour.

Noble's management is shareholder-friendly with a successful track record. But major risks lie ahead.

And when times were good, Noble operated with a shareholder-oriented management as it never made acquisitions using equity but instead used debt and internal cash flow; It ran a conservative balance sheet with a leverage ratio of less than 40%.

More numbers: Five years ago Noble was valued over one times the company's 2014 revenue. It now trades at less than half the 2018 revenue. It is also trading at historically significant discount to book value. At the end of 2014 the book value per share was $26, and during that year the stock traded hands as high as $33 and as low as $14. The minimum price to book value was 54%. Contrast that with today's pricing. Today, the company reports a book value of $18 per share and a two-dollar price tag is 89% discount to book value.

NE's price to book value per share over past decade
NE's price to book value per share over past decade

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Before I bought the stock of Gulport and Noble, I knew little about the gas and oil industry. The following two books tremendously helped: Written by Jens Zimmermann, The Oil and Gas Industry Guide: Key Insights for Investment Professionals  contains key valuation methods and industry knowledge. It is a somewhat technical book.

For broader understanding of the business, Bryan Burrough’s The Big Rich: The Rise and Fall of the Greatest Texas Oil Fortunes is a colorful portrayal of the industry's eccentric characters.

FOOTNOTES
[1] West Texas Intermediate (WTI) crude oil is the most popular oil benchmark.  
[2] For example, the 2014 leverage ratio was 45%; it is now 51%. The adjusted interest coverage ratio was over ten times in 2014; it is now one times.