Why have Investments in E&P Performed so Badly?

Introduction:  There’s a good chance that many readers’ investments in E&P have disappointed in recent years.  Even the super-sluggish Supermajors and mid-sized companies such as BG and Oxy have delivered better shareholder returns (often through nothing more than dividend yield) than small cap E&P.  E&P investors on London’s AIM market have seen share prices decrease by over 40%, over the last 3 years according to the FT:

 FT AIM E&P IndexSource:  Financial Times

So what’s driving investor thinking and can we expect any relief from this period of under-performance?

In this article I take the investor’s view and highlight the factors that have contributed to professional investors’ subdued interest in investments in E&P.  I include the good news also, to show what can be done when things work well.

Macroeconomics: oil demand is strongly correlated with economic growth and with the news from China and India that their economies are starting to slow, and further news that recent recoveries in the US and UK may not be sustainable, interest in oil and gas investment has waned.  However, support is provided by a weakening dollar (which often leads to higher oil prices) and the continued expectation that interest rates will remain low.

Oil and gas prices:  Expected oil price has a significant impact on investor sentiment towards the sector (see chart below) and here again the bears would seem to have the upper hand.  Concerns over global economic growth, and increased supplies from Iraq, Iran (with loosening sanctions) and oil shale oil in the U.S., have trumped short term disruptions in Iraq and political tension in the Middle East.

E&Y Oil and Gas Eye Index

Source:  Ernst and Young*

More worrying for oil and gas investors is the apparent disconnect between share prices and oil price in the E&Y plot above.  Over the last 18 months stable oil prices have been met with declining share prices.

Investor sentiment:  Currently investor sentiment towards the E&P sector seems to be very low.  This is partly explained by the investment cycle.  A potted recent history of investment in E&P would look something like this:

  • 2010 – 2012: a good run of exploration success by companies like Cove Energy and Tullow Oil results in strong share price performance.
  • New institutional funds pile into various high risk plays, underestimating the risks.  Examples include Chariot in Namibia and a host of Falkland Island explorers.  All raised significant funding, but did not deliver with the drill bit.
  • 2012-2013:  A continuing bad run of drilling results turned the initial enthusiasm to despair and investors exited.  Tullow Oil is again a good example of this.

The risk appetite amongst professional investors has been further reduced by the underlying financial and sovereign debt crises.  E&P is perceived by many to be the riskiest investment of all.

Many investors are now taking a “risk off” approach.

Exploration failure is, unfortunately, not the only example of recent poor E&P company performance.  Others include reduced production guidance, equity dilutions and arguments with host governments, to name a few.  Faith in the sector has been shaken.

Company performance:  so how do investors in small E&P companies aess likely returns, and current and prospective performance?  Typically the following are analysed:

  • Actual versus prospective growth:  reserves additions and production growth dominate here.  The recent good news from Forum Energy that production has started from offshore Philippines and that profits and production have increased at Empyrean Energy, have not been enough to offset negative news flow elsewhere.
  • Technical and non-technical risk performance:  mediocre drilling results (Faroe Petroleum) and poor government relations (Bahamas Petroleum impacted by a host government referendum on oil and gas) are just two examples from a raft of bad news.  Positive news such as Lekoil’s upgrade to resources and Afren’s reserves upgrade, both in Nigeria, have been well rewarded by the market.  Increasing project complexity and risk in non-OPEC oil is fuel to the fire for those that believe that risk managment performance is in decline.
  • Financing:  in today’s world balance sheet flexibility is rewarded by investors.  Companies with strong balance sheets are seen to be able to move quickly to monetise resources and grab opportunities.  However, investors seem reluctant to fund financially weaker companies that have great opportunities, especially explorers and developers.  AIM E&P funding at £621.2M in 2013 is a fraction of what it was in the 2000s.  Many believe that AIM O&G sector is too fragmented, and lacking the materiality that investors seek, and the materiality that E&P companies need to monetise projects.
  • Capital discipline.  The E&Y plot above shows that the oil price has been relatively stable for several years.  However, costs during this period have been rising steeply, and this has contributed to a softening of share prices.  Capital discipline is the new buzz word and it means that not all discoveries will get commercialised in the short term.
  • News flow generation:  Investors’ time frames are narrowing also.  Currently many seek news flow over a 6 month period, rising to 12-18 months for the big funds, in their target investments.  This comes at a time when project life cycles are getting longer, mainly due to the increased time required for access, seismic acquisition and exploration drilling.  The following events tend to move share prices up (or down):

Down:  Unfortunately for the sector much of the recent news flow has been negative and share prices have been punished.  Examples include:  equity issuance (Victoria O&G); production guidance decreases (Ithaca); capex increases; dry wells (e.g. Wessex Exploration’s dry hole in offshore French Guiana and Serica Energy’s dry whole in offshore Morocco).

Up:  Investors will reward the following with share price hikes:  discoveries (e.g. Andes Energia light oil discovery in Argentina, Trinity Exploration’s oil discovery in Trinidad); farm-downs (Bahamas Petroleum lack of farm-out partner has had a negative impact); and new license awards.

  • Good due diligence:  In addition to the above, the following are also typically addressed as part of investment good practice:
    • Regional geology and contracts/licences won ( with increased government take around the world applying further downward pressure to E&P company profits).
    • Company assets:  material prospects, resources and reserves.
    • Competing companies, either in the region or competing for future investment.
    • Business model, management team, corporate governance, strategy, exit strategy and any analogue transactions.

Current low share prices will be a concern to those sitting on paper losses.  Many will worry that one outcome will be increased private equity investment in the sector, crystalizing such losses.  Corporate action such as Spike Exploration’s purchase of Bridge Energy will not be welcome by some, especially in deals that are at less than NAV.

However, perhaps the pendulum has swung too far the other way and there are a number of companies currently trading at a discount to NAV and in some cases a discount to cash.  So what triggers will bring investment back to E&P and lead to a sector re-rating?

My top four triggers are:

  1. Economy:  global economic growth, particularly good news on China.
  2. Oil price:  firming, with a belief that price is on an upward trend.
  3. Company performance:  management teams that deliver on their promises, especially with the drill bit.
  4. Corporate activity:  consolidation of a fragmented AIM E&P market.

* Ernst and Young’s Oil and Gas Eye provides analysis and commentary on the top twenty AIM listed Oil & Gas shares by market weight.  The vast majority of these are E&P companies (rather than service companies).

Comments

  1. Julie Wilson says:

    I liked your synopsis on the small-caps. Exploration has really gone out of favour. I think one of the factors is also that investors just see better returns in other sectors that are benefitting (or are poised to benefit) from the growth in the US economy. Lots of US companies have very strong balance sheets which, as you point out, investors are keen on.

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