The Energy Sector Goes Into Survival Mode

by Ari Charney

With Canadian oil and gas producers cutting dividends and slashing budgets, it may be a surprise to some investors that analysts believe the country’s exploration and production (E&P) companies are better positioned to endure crude’s downturn than their U.S. counterparts.

North America’s energy renaissance has not only created a glut of production, it’s also created a glut of borrowing to finance this production. And while there certainly are Canadian E&Ps that are overleveraged, the average firm in Canada’s energy sector has managed to uphold the country’s reputation for fiscal conservatism.

Jeremy McCrea, an analyst at AltaCorp Capital Ltd told the Financial Post:

“Canadian balance sheets are in much better shape than they are in the U.S. Canadian average debt-to-cash flow runs around 1.9 times, versus many of the U.S. players that are four times, five times debt-to-cash flow. Our companies are likely better to withstand a downturn.

U.S. companies’ fiscal profligacy is best evidenced by the jump in issuance of speculative-grade bonds (otherwise known as “junk”) in the years since the Global Financial Crisis. According to Barclays, the U.S. energy sector now accounts for 14% of the high-yield bond market, up from just 5% in 2007.

At the same time, U.S. companies have done a somewhat better job of hedging their production on average than Canadian firms, though the hedging programs of our favorite Canadian E&Ps should buy these firms some time, at least through mid-2015.

The question is what happens if oil prices persist at current or even lower levels after that? For instance, some OPEC members caused further jitters recently when they said they wouldn’t cut production to bolster prices even if global benchmark Brent crude dropped to $40 per barrel.

In a live online discussion hosted by the Financial Post, three energy sector insiders seemed to agree that cuts to capital expenditures would most likely affect exploration, while firms would try to maintain or even ramp up existing production to offset lower prices with higher volumes.

As such, it could take at least another year, if not longer, for lower prices to lead to a net decline in production. Of course, production cuts along with a lack of exploration will eventually cause supply to fall below demand, possibly spurring the next up cycle.

For now, analysts expect crude prices to continue falling through the first quarter, before beginning a moderate rise.

We averaged the quarterly forecasts for North American benchmark West Texas Intermediate (WTI) crude offered by the 18 analysts who’ve updated their projections since Dec. 10.

Note that this is merely a subset of the forecasts aggregated by Bloomberg. With oil’s extreme downward volatility, we wanted to ensure that we only used forecasts where the commodity’s most recent moves were presumably accounted for in their models.

Among this subset, the consensus is for WTI to rise to an average price of $66.84 during the second quarter, $72.68 during the third quarter, and $76.75 during the fourth quarter.

According to Bloomberg, the generic WTI futures contract recently traded near $56.52, so the aforementioned forecasts sound downright optimistic by comparison. Indeed, the risk is still to the downside, at least in the near term.

But while individual companies can’t possibly move as fast as the market, they’re hardly static. And the myriad adjustments to spending, exploration, production and costs, not to mention geopolitical developments, could cause oil’s eventual ascent to be just as sudden as its downturn.

While many companies are going into survival mode, well-capitalized firms will take advantage of crude’s selloff by acquiring solid assets on the cheap from troubled companies, even though they, themselves, are hardly immune from the pain.

As Crescent Point Energy Corp (TSX: CPG, NYSE: CPG) CEO Scott Saxberg recently told Bloomberg, now is “a great opportunity to look for consolidation opportunities … and take advantage of guys who have weaker balance sheets.”

And sure enough, Spanish energy giant Repsol has already swooped in to acquire Canada’s Talisman Energy (TSX: TLM, NYSE: TLM), a hold-rated constituent of our How They Rate universe.

The Spanish firm had been looking to replace assets that had been nationalized by Argentina. After Repsol identified Talisman as its top target, it patiently waited for an opportune moment.

Although Repsol is acquiring Talisman at a 60% premium to the weighted average price of the 30-day period preceding the announcement, the CAD9.33 per share offer (USD8) is still sharply lower than the CAD14.31 per share the stock averaged over the trailing five-year period, as well as its trailing-year high of CAD13.06.

Absent this bid, by most accounts, Talisman faced a number of difficult choices, as outgoing CEO Hal Kvisle said lower oil prices were creating a cash crunch that would impinge upon the company’s ability to invest in new growth while servicing its debt. As such, both analysts and institutional shareholders alike see this deal as Talisman’s best option.

For shareholders with a long-term perspective, such deals are disappointing, since firms will likely be taken out at levels below their cost basis. On the other hand, if a weak firm is truly at risk of bankruptcy, then this scenario is vastly superior to a total wipeout.

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