Why High Gas Prices are Here to Stay
This is Part 1 of Energy Policies in America. Today we look at how COVID forever changed the way energy companies manage their business.
Cartoons of the Week:
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No, The President is Not in Charge of Gas Prices
I cannot tell you how many times I have read and/or heard people talking about how the US is not energy-independent (hint we are…I talk about it HERE).
Besides the energy-independent story, I also hear how the President is causing high oil prices.
Here is the bottom line: The president has no effect on oil and gas prices. There I said it.
Sure, the President’s policies can affect oil drilling and therefore prices over the longer term.
He can also send messages in the short term that will affect the sentiment within an industry. On this point I would agree to shut down the Keystone extension and talking about oil windfall taxes is not helpful.
But decisions to drill or not drill along with production rates have nothing to do with the President and everything to do with the market, oil price volatility, and COVID.
COVID?!?!?
Yes, COVID. You see, COVID has impacted gas and oil prices more than you could ever imagine. It forever changed the way all C-suit executives think about their companies.
Let’s put on our CEO and CFO hats for a few minutes and discuss why the pandemic has ushered in high gas prices for the foreseeable future
Let’s discuss…..
Growth at All Costs
For the past 15 to 20 years, US shale oil companies have focused on one thing and one thing only — GROWTH.
Debt-financed growth was the name of the game. And with an abundant amount of cheap debt, it paid to use it.
If you were a CEO or CFO of an oil or gas company in the 2010 time range, your thoughts went like this:
Focus on Free Cash flow….No WAY
Focus on Profits….YOU KIDDING ME
Focus on increasing margins…STOP BEING A KAREN
Investors and the market want one thing and one thing only…
DRILL BABY DRILL!!!!
In the early 2000s, a new technology came along called horizontal drilling. I went into great detail HERE on how this changed the world. Please read my post from Week 13, 2022 Titled “Why are Gas Prices so High? to get more details.
As we moved into the 2010s, energy companies started to perfect this technology.
Per a BLS report:
“What changed in 2012 and 2013 that offset the upward pressure on petroleum prices was the input of increased supply, primarily from the United States. Prices remained between $90 and $100 a barrel over most of the 2-year period.”
From 2010 through 2016, companies were factoring in $100 plus oil prices for many years to come.
As you can see below, shale oil and gas production skyrocketed for each incremental dollar spent on drilling.
This increase in productivity and efficiencies corresponded with a steady drop in crude oil prices (red arrow below).
This started an interesting paradox.
Investors were rewarding companies for growth. To satisfy investors’ cravings, CEOs and CFOs focused on efficiencies and production growth. However, the more they focused on growth and the lower oil prices moved.
If an executive wanted to change their position, not only would their stock be lower due to oil prices moving lower, but they would also be looked at as the company who cut their growth outlook, impacting the stock price even more.
Stuck between a rock and a hard place, they continued to drill.
You can see this trend when looking at the industry’s free cash flow. This is cash left over after paying for everything INCLUDING the building of new wells.
Shale company’s free cash flow was negative as far back as we can see (the chart below shows from 2005 to 2020). Despite $140 oil in 2008 and many years of over $100 a barrel oil prices, US shale oil companies were making NO MONEY. NONE!!! Every dollar they made above operational costs they shoved back into spending on well discovery and drilling.
DRILL BABY DRILL!!!
Despite investors’ push for growth at all costs, each incremental unit of growth did not make them more but cost them more.
As a result of a focus on growth at the expense of burning cash, debt levels inched higher each and every year.
Let’s look at a few different measurements to get an idea of how bad it was.
Below is a chart of long-term debt growth (energy sector circled in red — focus on the gray lines which highlight 2010–2017).
When we looked at leverage ratios like net debt to EBITDA, the 2010–2017 period was significantly worse (the higher the number the worse off you are).
There was one measure of debt that improved over this time. Can you guess what it was?
I will give you a hint. It has to do with central banks’ free money policies.
You guessed it. Interest coverage. While debt levels were skyrocketing higher, the interest payments on those debts moved lower, making companies more comfortable with holding higher amounts of debt.
All through the 2010s, energy companies were giving up financial prudent measures in exchange for growth. All because of lower interest rates and investors’ push for growth.
DRILL BABY DRILL!!!
As Deloitte stated in their insights piece from 2019 about the rise of corporate debt:
“A quick look at the net debt-to-EBITDA ratio shows that it has gone up for all sectors except industrials and real estate (figure 11), indicating a decrease in their ability to repay debt. The energy sector, where this ratio has gone up by 1.8 percentage points between 2010 and 2017 — contrasting with declines in the previous two recoveries — is the most striking in this regard.”
Bring on the 2015 Oil Price Crash
The growth game worked fine with cheap money and $100 crude. Companies made no money but had visions of grandeur about future profitability.
With all the focus on growth, the world started to have more oil than it needed. By the beginning of 2015, we had a glut of oil around the world.
As stated in a report by the US Bureau of Labor Statistics Behind the Number May 2015:
“World supply has risen over the past couple of years, largely spurred on by a growth in production from the United States. The horizontal drilling technique now being utilized in the United States and Canada gives access to previously unattainable sources of oil. Since peaking in 2005, U.S. dependency on foreign petroleum has declined.
U.S. production rose to a 24-year high in 2013, keeping petroleum prices stable despite strong demand and geopolitical uncertainties. Domestic production increased by 1.0 million barrels a day in 2013 from 2012 and exceeded U.S. imports for the first time in 20 years.”
With the combination of US producers growing at all costs, a strong US dollar, and Saudi Arabia not cutting production in OPEC to offset the new US supply hitting the world markets, you had a lethal combination of too much oil and not enough demand (opposite of what we are experiencing now).
After peaking at $107.95 a barrel on June 20, 2014, oil prices plunged to $44.08 a barrel by January 28, 2015, a drop of 59.2 percent in a little over 7 months!!!
Many thought shale producers would focus more on profits instead of growth after this dramatic drop in oil prices.
But that was not the case.
As you can see below, after the drop in 2015–2016, shale production (lime green bar) started to rise again.
Not only were shale companies continuing to grow even at these lower oil price levels, but we also started to see a trend in mergers and acquisitions.
If you cannot hit your unnatural growth targets by drilling, you can hit them by buying other companies. Who cares about the debt? We need growth!!!
As you can see below, the deal count spiked to new highs in 2016–2017 despite oil prices being half of what they were in 2014. Most of these deals were financed with, you guessed it, new debt.
While these mergers continued at near-record paces on the back of new debt issuance, management teams continued to sell investors on the opportunities these deals provided and on the long-term growth potential.
Case Study — Occidental Petroleum (OXY)
Since 2000, Occidental Petroleum, otherways known by its ticker OXY, was one of the strongest performers in the energy space. They always had one of the best balance sheets in energy and took pride in not using debt to grow. All their acquisitions and mergers were funded with cash generated from the business.
This all changed in 2016.
With their focus on being the biggest company with the highest growth rate in the industry, they needed to make more and more acquisitions as oil prices moved lower and lower.
This M&A boom pushed acreage prices higher and higher.
Because of the lower oil price and higher acquisition rate, OXY began to use debt to finance their new deals.
By 2016, their net debt approached $10 billion. Their net debt (debt on the balance sheet — cash) to cash flow from operations ratio moved up to 2.6X (they have an average of 0.2X from 2005–2014).
Acquisitions Do Not Equal Increase in Shareholder Value
In a report below by Deloitte, you can see most of these new oil and gas shale deals eventually lost money for shareholders.
As Deloitte stated:
“Our analysis of the top 100 shale deals by value since 2014 shows mixed results, with more than half the deals realizing below-average operational (free cash flow) and shareholder (total shareholder returns) gains. In terms of deal value, 35–45 percent of deals turned out to be value-destructive, operationally or financially.”
With the continued use of debt to finance artificial growth through M&A, combined with lower oil prices around the world, bankruptcies started to spike higher. Law firm Haynes and Boone saw more than 400 oil and gas-producing companies file for bankruptcy between 2015 and 2019.
Enter 2020 and COVID
In a blink of an eye, the world came to a stop. With the demand for oil 30% lower within a month, the price of oil did something we have never seen before. It turned negative!!!
As you can see below, the WTI futures price of oil dropped to a negative $30 on April 20th, 2020.
The glut of oil had no place to go. Storage was quickly hitting max capacity. As a result, new oil production from around the world had nowhere to go, pushing oil to a negative price.
Shale companies went into a panic. All the growth they did for the past decade stopped overnight, leaving them with only a debt hangover to show for it.
Practically overnight, energy bond prices saw drops of 30 cents on each dollar. the debt markets froze. Any acquisitions in the pipeline were canceled. All debt due was unable to be refinanced.
As a Bloomberg article from March 2020 stated:
“The average spread over Treasuries for companies in the Bloomberg Barclays High Yield Energy index has surged above 10% for the first time since 2016, back when hundreds of energy-related companies were going bust or restructuring.”
The amount of oil and gas debt outstanding trading at distressed levels (under 70 cents on the dollar) spiked to over $81.5 billion!!!
With so many models forecasting oil prices of $55–60 over the long term now looking unrealistic, the new reality of the world forced CEOs and CFOs to make very tough decisions.
As Bloomberg stated:
“With cash flow models based on oil prices above $50 to $55 a barrel. Some of those promises were aggressive even back then, and now they are utterly unsustainable at $30 a barrel.”
The entire industry as a whole was in trouble.
What Happened to Occidental Petroleum in 2020?
In August 2019, as OXY was looking to continue its industry-leading growth, it decided to acquire Anadarko Petroleum Corporation (APC) for $55 billion!!!
At the time, the CEO mentioned they would see $3.5 billion a year in cost and spending savings called “synergies”.
After the deal, JP Morgan’s estimated their 2021 debt level at $50 oil price, at $13.46 billion, or a 2.3X net debt to EBITDA multiple.
This deal added the most amount of debt to the OXY balance sheet in history. It also created the highest level of leverage ever in the company’s history.
At $50–60 a barrel of oil, they felt like the deal was worth the risk. Little did they know not even 12 months later, the price of oil would be half of what they had modeled.
In March 2020, JP Morgan ran a new analysis of $30 oil prices. As you can see below, OXY’s net debt to Cash flow (similar to EBITDA) spiked to over 7X. This is distressed debt land!!!
At these levels, if OXY wanted to refinance its debt, it probably would have to pay an extremely high-interest rate or be forced into giving up ownership, or potentially be pushed into bankruptcy.
Overnight, their credit rating was cut. They were forced by their creditors to cut their dividends, cut Capex, and stall all future growth projects. They had to pay their preferred dividend not with cash but with more stock shares. Owners of the stock just got diluted without them knowing.
It’s like you buying a house only to learn later that another family will be sharing it with you.
At the end of this ordeal, Warren Buffett received a special dividend for being a preferred stockholder. This special dividend would give him ownership of over 9% of the company in the future at a certain stock price.
The old management team at OXY would have looked forward to a time like they saw in 2020. A time to use their minimal debt and high cash flow to purchase assets on the cheap.
Instead, because of the use of debt during the “drill baby drill” years, they were now forced to sell to the only guy with cash, Warren Buffett, and to give away the house in order to survive.
A new Age for Energy at the Expense of your Pocket Book
On the back of the pandemic, many oil companies now can care less about growth.
Instead, they are using their newfound wealth to buy back debt, strengthen their balance sheets, and pay dividends to their shareholders.
As you can see below, shale companies are on the verge of making over $200 billion this year in cash flow, more than the past 20 years combined!!!
This is enough cash to potentially make the industry debt-free by 2024!!!
From 2010–2019, the shale energy producers burned through $300 billion in cash and are finally making this money back in 2022–2023.
This trend is not just in the US. Instead of spending money on growth, global oil companies are keeping the cash.
Global oil and gas companies will generate a record $1.4 trillion in free cash flow in 2022!!!
US producers, for their part, are focused on paying down debt and paying out special dividends.
S&P 500 Energy Index companies paid out $16.4 billion in cumulative dividends, which is up 15% from $14.3 billion in the second quarter and a whopping 49% from $11 billion a year ago, according to data compiled by Bloomberg.
As Bloomberg stated:
“The key difference with this year’s oil and gas boom is not so much high prices, but the industry’s lack of capital expenditure compared with historical norms. Global operators are spending about 60% less on oil and gas production projects now than they were in 2014, the last time oil was trading around $100 a barrel, Deloitte’s data show.”
If you are the CEO or CFO of an energy company today, your goal is to de-lever as fast as possible.
If you face another downturn, or disregard all the debt on your balance sheet, you are putting your company in a bad position. COVID taught them no one is safe. And because of the new central bank policy to fight inflation, any debt moving forward will have a near 7% — 10% interest rate attached to it.
So instead of trying to hire new personnel (the industry lost over 50,000 employees since 2019) or paying $8 million for. a new well that may come online in 6–8 months, management teams are using that $8 million to pay down debt, pay dividends, or increase their cash holdings.
This can easily be seen below in the number of new rigs in operation. We are well below peak levels still, even with oil near $100.
As stated by S&P Global:
“Nobody wants to step up activity,” Truist Securities Inc. oil and gas analyst Neal Dingmann said in a phone interview Sept. 1. “So, you’re not reinvesting or piling much money back into the ground and growing faster. Obviously, you’re going to have a lot more coming back.”
Below you can see the cash on hand at most energy companies is well above where it was just 12 months ago.
After they get more comfortable with their newfound wealth, balance sheet success, and cash on hand, they will probably focus their growth efforts more on natural gas production instead of oil production.
With the crisis in Europe not going away, the strategic view is to focus on the commodity that should have less volatility and more stability over the next decade.
What to Expect in 2023
Prior to the pandemic, with oil prices at these levels, energy companies would be focused solely on the well count, rig count, and growth statistics. But the pandemic changed everything.
Oil output is now 11.8 million barrels a day out of shale, well below the peak of 13 million we saw prior to the pandemic.
The new CEO of Chesapeake Energy, who filed for bankruptcy in 2020, said it best:
“What’s different today than the past . . . is that we are allocating capital in a way that maximises returns to shareholders, rather than maximising [production] growth.”
As Bank of America’s credit team recently stated:
“Management teams across energy subsectors are focused on allocating strong free cash flow towards obtaining strong balance sheets. This is driving material debt reduction through bond buybacks and tenders as well as redemptions of near-term maturities.”
Take a look below under comments by management for different companies. They are all focused on one thing. Debt reduction. Not growth production.
As for our friends at OXY, during the pandemic, their stock price fell from $80 per share to under $10 per share. There was talk of them potentially having to file for bankruptcy.
They pulled out all measures to stay afloat. They are now using the cash windfalls to pay off its debt (you can see comments above), so far paying off about $10 billion this year alone.
As their CEO recently stated:
“There are lots of headwinds to increasing production worldwide. We can’t destroy value and it’s almost value destruction if you try to accelerate anything now.”
Read that statement above again. She basically stated that at $80 oil domestically and near $100 oil internationally, any growth initiatives are value-destroying.
What does this mean for you?
It means high gas prices are here to stay. What drove extremely low gas prices in the mid-2010s (horizontal drilling technologies, cheap money, and focus on growth drill baby drill) will never come back.
More importantly, since we are seeing minimal growth here in our shale regions, OPEC, Saudi Arabia, and Russia again have power over the price we are paying at the pump.
I don’t know about you but for me, this is unacceptable. Oil again is controlled by countries who would love to hurt us economically and financially.
We need to do better as a country. Our politics is so focused on the next polling numbers or the next election that we have forgotten to look into the future.
The main job of a leader, be it a CEO or president, is to get past the day-to-day noise and focus on the long term. We are seeing that today with the way shale companies have changed their strategies.
We need this from our politicians on both sides.
We have an abundance of natural gas. We are the leaders in nuclear technology. We are the largest producer of the key ingredient needed for hydrogen technology.
We are not the leader in battery technology. China right now is kicking our butt. More importantly, the minerals needed to make batteries are all in China and Russia.
We need a change in our domestic energy policy before it's too late. This change will not happen unless you as a citizen are informed and educated about the alternatives.
That will be my goal in December. To take a look at what I feel are the keys to a carbon-free, Saudi, and Russian-free, energy policy.
For the amount of money we spent on COVID policies, if used for the right energy policy, within 10 years, we would be well on our way to a carbon-free energy policy that would never again be impacted by foreign countries' policies.
I am off all next week. I hope you all have a wonderful and safe turkey day holiday. Please take time to give thanks for all the wonderful things in your life, for what you focus on and cherish become more.
Have a wonderful week!!!
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https://www.vox.com/2014/12/16/7401705/oil-prices-falling
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