Is Crude Drilling South or Barreling North?

Since late 2014, the United States domestic energy market has been in the midst of the worst industry downturn in nearly half a century. But investors are lying in wait, looking for the opportunity to jump back in. Optimal timing remains the only factor holding back reinvestment.

With crude oil’s recent price hovering around $50 per barrel, the probability of reaching sustained equilibrium at these prices is low, and the probability of continued decline is even lower. While overall energy market fundamentals continue to raise eyebrows, an investigation of the likelihood of improvement is increasingly necessary. Recent market flux and mergers and acquisitions activity signal a possible revitalization of the stagnant domestic oil and gas industry. Upstream companies, those that search for and extract oil and gas products, are currently attempting to both trim fat to improve their balance sheets and acquire new holdings to position themselves for rapid growth upon further price recovery.

These deals offer insight into possible positive attitude clues from the executive teams behind them. With companies willing to take on extra debt or raise funding through secondary equity offerings, mergers and acquisitions in this area should be taken as a strong bullish sign for investors. In particular, mergers and buyout attempts among smaller midstream companies increased precipitously over the last several months, which hints at the concerted industry effort to consolidate and improve operations efficiency.

However, the largest deals brokered over the summer season are perhaps the most indicative of positive industry sentiment. Recent deal activity by the larger upstream firms has focused on attempts to acquire new oil and gas plays ripe to be highly profitable when the supply glut ends.

Range Resources’ $4.4 billion acquisition of Memorial Resource Development exemplifies just this style of thinking. Memorial Resource Development held promising natural gas reserves in Northern Louisiana, making the company’s buyout essentially an investment in future production for Range Resources.

“The merger [would provide] core acreage positions in the two highest return, lowest cost natural gas plays … [and] complementary assets positioned near expanding natural gas and NGL demand centers.” Drew Cozby, former CFO of Memorial Resource Development explained the rationale behind the buyout given current market conditions to the Dartmouth Business Journal.

EOG Resources’ $2.5 billion merger with Yates Petroleum Company falls along the same lines. EOG Chief Executive Bill Thomas described the addition of Yates’ proven crude positions in Texas’ Delaware Basin and the Powder River Basin of Wyoming and Montana as “paving the way for years of high-return drilling and production growth.” With crude prices still below the breakeven $61 for the Permian Basin estimated by Labyrinth Consulting Services Inc., the deal’s creation of a 574,000-acre position in the heart of the region appears to be either a questionable gamble for the foreseeable future or a bold positioning strategy at the heart of Texas’s most profitable drilling region.

Expected to close by the end of 2016, Anadarko Petroleum’s $2 billion purchase of deep-water drilling access via Freeport McMoRan is also worth noting. Larger energy and exploration companies, such as Anadarko, continue to feel the weight of high proportional debt (38 percent Debt-over-Enterprise Value ratio relative to industry comparable numbers that hover around 28 percent, according to Yahoo! Finance) from low oil prices and are focused on generating the cash flow they need to fund deals that provide access to yet more profitable plays. The Oil and Gas Financial Journal estimates that $3 billion in free cash flow coming over the next 5 years from additional Gulf of Mexico reserves will allow them to do just this, with greater targeted investment onshore in the promising Delaware and Denver Basins.

What is the net result of the previous three deals? According to PLS Inc., merger activity within the industry was the highest in July 2016 at $8.4 billion since the pre-price-crash era, when the highest tally was $12.9 billion in July 2014. Aside from being seismic boosts in production deal flows that the industry has lacked for the last two years, these deals combined are the largest upticks in activity, as big upstream companies vie for exposure to the most profitable onshore regions of US natural gas and crude.

The frenzy among the nation’s largest public energy companies to complete deals in the Texas Permian Basin region has left private equity investment in their wake, according to Mergermarket. The competition for exposure has led to multibillion-dollar entry fees to the region — yet the failure of private equity firms to win deals thus far means that an excess of funds remains for investment around the Permian Basin and elsewhere domestically. Thus, while investments in choice reserves have already raised prices beyond suitable levels for all but the largest buyers, a strong bullish sign for the market remains in the large amount of capital pending deployment.

In terms of market momentum, the laymen investor looking to ride on the coattails of those first to act can only hope the deal frenzy delivers tangibly better equity valuations or higher crude prices. The willingness to spend billions on buying out firms certainly exudes confidence, but this is a market driven overwhelmingly by supply and not demand. With the energy industry’s ability to continually dodge the bullet of demand destruction from the time-consuming and costly nature of finding suitable alternatives, consumers will not need less oil any time soon. Thus, oversupply will continue to be the dominant variable in oil price fluctuations for the near future.

In this vein, broader geopolitics continues to signal that the opportunity for investment is still on the horizon. While positive signals came from the Organization of Petroleum Exporting Countries (OPEC) talks at Algiers, prices may witness the same malaise well into 2017 despite the initial optimism surrounding the output freeze agreement. As per OPEC, its tentative output cap for 2017 will set production levels lower by only 750,000 barrels per day from a previous 32.5 million barrels per day. Considering this number in the context of Russia’s 400,000 barrel per day increase in production for the month of September and the historic tendency for OPEC members to ignore individual quotas, the cutback will probably have relatively minor significance.

Yet, the OPEC decision to decrease output without accord from Russia is confusing. Based on each nation’s disagreements at the last OPEC meeting in April, Saudi Arabia and Iran should be the two states continuing to overproduce as each tries to win market share. In the same competition is Russia, who is now left to fill the void created by OPEC’s decreased production. Moreover, pressure from officials in Moscow will reinforce the predisposition of the country’s oil majors to pump more in order to spur economic growth after the freefall of the Russian GDP and the Ruble over the last two years.

While OPEC’s decision also eliminates geopolitical uncertainty from both Saudi Arabia and Iran through the next year, it preserves the United States’ role as the swing producer nation. Any increase in production by Russia will have to be met by decreased production from the United States, hence its role as the swing state. More specifically, Russia will use increased output as a weapon to force the United States to concede market share, which the domestic producers in the United States will do to protect prices.

From the OPEC arena, the increase in Russian production would have been anticipated, especially given Russia’s attendance at the OPEC talks in Algiers. Thus, much like the Saudi decision to flood the market with excess supply in 2014, Russian overproduction will keep American output subdued despite the promising developments in merger activity from domestic companies.

Should Russia continue to flood the market, as data from its third largest producer Rosneft OAO suggests it will, any gains created by OPEC cuts will be reversed. Worse yet, should Rosneft production levels reach a forecasted 20 percent increase for 2017, the market could be left with an even worse supply glut. As much as US producers would benefit from a return to normalized supply levels, many companies have short positions already prepared for its continuation.

When asked about the geopolitical climate’s effect on the balance sheets of US producers, Drew Cozby, former CFO of Memorial Resource Development, stated his company confronts these challenges by “actively hedging commodity exposure and attempting to lock in well economics … [to minimize] downside exposure.” Yet, confronting a market oversupplied by several millions barrels of excess production each day is nearly impossible.

Potential investors should also understand that these positions will, at best, only partially limit the full downside to Russia’s destructive overproduction, and that the market will probably remain oversupplied. Russia will hold the key to a price recovery in 2017 based on these terms, but the role is one they will not accept. Thus, the tide of domestic optimism and increased mergers and acquisition activity may remain overshadowed for the foreseeable future by these factors as they combine to stagnate the industry’s rebound.