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Investing in oil and natural gas stocks is not for everyone. In fact, the recent volatility over the past four years or so has been very unstable. The core focus of the Lean Long-Term Growth Portfolio (LLGP) is to invest in holdings for the long-term. The portfolio is actively managed, so “buy-and-hold” is not necessarily how every holding is managed.
It is to this point that oil and natural gas stocks fit. But before delving into the holdings and management, I would like to express some sentiments regarding how I view these industries. First, I have chosen to invest in the more controversial U.S. companies focused on exploration and production for oil and gas via horizontal drilling. These include Pioneer Natural Resources (PXD), Concho Resources (CXO), Rice Energy (RICE) and Rice Midstream Partners (RMP).
This decision is based upon a couple of things. The LLGP has a long-term investment horizon, 30-plus years, and I am inclined to seek growth in this area rather than to hold any of the oil majors. Second, I view the growth in fracing as a play to gain a stronger market position over the long-term. This is interesting as it can have an impact on pricing over time.
The substantial increase in U.S. oil production has impacted global supply and demand. Prior to the shale plays’ growth, the Organization of the Petroleum Exporting Countries (OPEC) was able exert more control over supply to reach optimal revenue generation from oil demand. This benefited non-members dependent upon the price of oil as well since they could play the same game once substantial price increases occurred.
However, as the U.S. has become a stronger producer, it has not been as easy to play this game. The recent energy correction driven by oversupply was a strategic move to attempt to reduce capacity for the sake of the near-term management for global oil. However, the opposite effect is now in place, where many countries are producing high levels of oil, especially those solely dependent up on it for national revenues.
We need to ask ourselves, if a nation’s primary revenue source has been substantially impacted by lower prices, what is the response? Clearly to produce as much oil and natural gas as possible in order to make some of those lost revenues. I view this as a very interesting event, and I support the U.S. attempting to compete more vigorously within the global marketplace. So far, oil prices have remained below $60 per barrel and natural gas prices currently reside below $3 per million Btu.
There are of course many other variables globally that can impact the prices of oil and natural gas, especially geopolitical events. But the fundamental shift with U.S. production capable of growing over the long-term is a paradigm shift, as has been the case since prices have declined form the summer of 2014 highs.
The above chart provides the year-over-year (YoY) change in Brent and Cushing spot market pricing. As can be seen, energy prices expanded from the first quarter of 2016 through February of 2017. Since then, prices have again contracted to the June low-point. Prices have more recently again moved above the $50 per barrel mark.
The $50 to $60 per barrel area is a critical one as many unconventional E&Ps believe that they can operate not only profitably, but grow within operating cash flows. This term has been talked about a lot lately in a negative context as critics of shale drillers believe that most operate on borrowing funds (borrowed time, too) with no end in sight for this to occur.
The Permian Basin has been a core driver for increased production as evidenced by the oil rig count performance over the past year. Through the first week of August, rigs were up 44 percent for the year, and 114 percent YoY. Similar growth rates have also occurred in the Marcellus and Utica shale gas plays.
Confirming improving production growth, Pioneer, Concho, Rice Energy and Rice Midstream all beat analyst estimates for both revenues and bottom-line results. However, some have questioned whether growth will be sustained.
Another major item which has gained more public discussion is the focus on the reduction of oil dependency. Some are calling for autonomous vehicles and the shared economy to completely shift the cost of transportation, which will ultimately substantially reduce consumption of fossil fuels.
These viewpoints are in the strong minority, but they are gaining momentum, and investors should not overlook minority momentum. In the U.S., especially nowadays, special interests can turn the tables as social engineering is becoming more accepted and occurring at a more rapid pace.
In summary, I am focused on quality shale plays as the competitive landscape is changing. I view the U.S. as an increasing exporter of oil and natural gas as a long-term positive. Technology tends to go through initial bust phases before it gets it right. In 1999, everyone thought we would buy everything online; it didn’t happen, but today, we have seen exponential growth in e-commerce. But traditional retail is still a stalwart. I view the same type of progression for fossil fuels; twenty years from now there will be progress for less dependency on oil, but oil will still be in demand. For these reasons among others, I have chosen to look for aggressive growth potential rather than lessen the risk. Oil stocks are a traders’ market, so there is no playing it safe, but rather win or lose.
LLGP Energy Holdings and Management
As stated, I own Pioneer, Concho and Rice Midstream. Rice Energy was initially purchased in mid-December of 2016 for a cost-adjusted basis of $21.66 per share. The position was averaged in early February at $19.62. The entire position was liquidated above $27 for a realized 32 percent gain. The liquidation price was slightly higher than the expected acquisition price. The decision to sell was more focused on reallocating cash rather than concerns of the deal being consummated.
Recently, Rice entered into a definitive agreement to be acquired by EQT Corporation (EQT). Aside from mergers, oil-related stocks have been challenged through early-August. However, oil majors have outperformed Pioneer Natural Resources, Concho and Rice Midstream serving as better investors to-date.
I am OK with this outcome thus far. Rice Midstream was hit as the EQT deal will shift the expected asset drop-downs to EQT Midstream Partners (EQM) rather than Rice Midstream. Lately, Rice and Rice Midstream have traded inversely — mostly from the activist engagement from Jana Partners looking to break up the EQT and Rice merger. Rice still has managed to trade at a substantial premium over the purchase price. Rice Midstream has rallied by around 13 percent from its lows after the merger announcement.
Before any though of something like this occurring (although the risk section of the 10-K clearly stated Rice Midstream’s vulnerability), an initial position was added to the LLGP with a cost basis at $24.18. After the plunge, the position was averaged at $19.02. Including one distribution, the position is down at -7 percent today.
If the deal does get completed as expected, EQT will also own a 28 percent stake in Rice Midstream. For investors interested in getting an overview of the Rice Midstream’s second quarter result I recommend reviewing the financials and the recent article from Jenks Jumps.
Performance during the quarter was very robust to say the least. The distribution was increased with the current yield above 5 percent. Rice Midstream has long-term agreements in place for Rice’s core E&P operations. This area will be a core focus for EQT after the merger. With an equity stake within Rice Midstream already, it makes sense for an eventual buyout over time. As long as Rice Midstream can continue to display organic growth and sustainable moderate distribution increases, the stock should do well from this lower valuation.
The stock may seem a little pricey at over 12 times EBITDA, but gross debt-to-capital is very low and gross debt is only 1 times EBITDA. Based on the reduced valuation, Rice Midstream’s profit and free cash flow margins were at 60 and 26 percent respectively as of the June quarter on a trailing 12 months (TTM) basis; again, the dividend yield was at 5.4 percent. Rice Midstream is a hold allowing for opportunistic buys below $20 per share, with near-term potential to be acquired.
Pioneer and Concho are similar investment opportunities, both for where the operate and by their financial strength. My timing buying these stocks was not terrible, but oil prices had just recently eclipsed the $50 per barrel level; both initial purchases were made in mid-December.
Since this time, Concho has been averaged once in early May. The average unit cost is at $133.26. Pioneer has been averaged three times since the initial purchase: mid-May and twice in early August. The average unit cost stands at $156.55.
Recently, negative sentiment has increased regarding shale plays. Pioneer was especially hit hard as the company reduced its capital expenditures deferring well growth (30 wells) for the year to 2018. Additionally, the company spent a lot of time explaining historical trends of its oil versus gas splits as gas increased faster than expected. Operational issues provided the perfect storm of a negatively interpreted report sending the stock price crashing from north of $160 to south of $130 in a matter of days.
Concho’s report generated a less volatile reaction for the stock price and displayed signs of strength soon after the announcement as hiccups were avoided. The big debate on these companies continues to be focused on valuation, with many arguing that current levels, even after recent declines are too lofty. I disagree.
Both Pioneer and Concho trade around 11 times EBITDA. Both companies have low leverage ratios with gross debt-to-capital below 25 percent, with Pioneer’s gross debt at 1.3 times EBITDA and Concho’s at 1.6 times. And despite some stating that these companies are cash flow negative, I beg to differ on this front as well.
I recognize that Pioneer and others make statements surrounding the goal to spend (capital expenditures) within operating cash flows. The simple equation of operating cash flow minus capital expenditures is one way to get to a free cash flow. However, almost every single company often has dispositions of assets, equipment, etc. Whether an asset provides a return on investment, or is sold for cash, either way, both contribute to positive cash flows. As such, I am inclined to include disposition of assets as part of the free cash flow equation. Even if you don’t, this cash flow gets added in regardless.
For Pioneer, and based on this adjustment, the company was free cash flow positive on a TTM basis as of the June quarter. In fact, as of yesterday’s close, Pioneer sported an 8.4 percent free cash flow margin. Concho similarly was free cash flow positive with a 4.5 percent free cash flow margin.
An important point to note, whether you buy this logic or not, is that both companies have witnessed much stronger cash flow performance relative to capital expenditures during an arguably more challenging period of time. One could counter-argue that as prices increase these companies will simply get back into an over-spending cycle. But we are not at that point yet, so it remains to be seen whether further growth will indeed lead to stronger cash flows.
What is evident is that Pioneer and Concho have the flexibility to weather commodity price volatility. Both companies have relied upon share dilution to raise cash rather than to depend solely on leverage. Even with recent dilution, both companies offer investors long-term potential as oil and natural gas prices ebb and flow.
As I stated early on, investing in oil and natural gas stocks is not for everyone. In fact, short-term traders and speculators are highly impactful on daily stock price movements. Even investing in oil majors is no cake-walk. Some might think that having a dividend payment would alleviate some of the volatility and speculation, just tell that to ConocoPhillips (COP) or Kinder Morgan (KMI) investors.
In all, Concho is down in line with oil majors from the summer of 2014 stock price peak. Pioneer is down a bit more. This year, all holdings within the LLGP have been laggards versus oil majors and other peers. Oil service and frac sand companies have witnessed even worse performance in some cases.
The strategy for Rice Midstream is to consider averaging on any weakness below the $20 level (we are getting close). The 32 percent realized gain on Rice was timely and a good return over a seven-month period. Pioneer and Concho will be managed similarly as Rice Midstream. Price targets for further averaging will be consider in the $100 to $110 range for both companies.
Disclosure: I am/we are long CXO, PXD, RMP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.