May 2016

The price of oil per barrel and the price at the pump dominate the news and are complicated by machinations with the Organization of the Petroleum Exporting Countries (OPEC) and international diplomacy, as well as concerns about the environmental impact of drilling. Oil is so pervasive in our economy that it impacts us all in the markets – far beyond the price per barrel. So we asked our internal experts at our affiliate, Westwood Management Corp., Todd Williams, CFA – Senior Vice President and Portfolio Manager for our Master Limited Partnership (MLP) team and Bill Costello, CFA – Senior Vice President and Portfolio Manager for our Small Cap team, to weigh in on what they are seeing relative to energy, the effect it is having on the markets today and what they see as they look ahead.

Over the last two years, oil has traded from nearly $100/bbl and hit five-year lows in January in the mid $20s. What effect has this had on producers and their balance sheets? What are the main factors of this volatility, and what do you expect to see happen with oil through year-end?

The decline of oil prices over the past two years from nearly $100 to the mid $20s has had a devastating impact on the industry. During that time over 130 companies, both oil service and exploration and production companies, have filed for bankruptcy under the burden of over $55 billion in debt. The main factors for the volatility and price collapse were increased supply along with weaker demand and a change in tactics by OPEC, specifically Saudi Arabia. The main factor was the amazing growth in U.S. production driven by the oil shale development. The U.S., which was limping along to produce ~ 5 million barrels a day between 2006 and 2011, saw daily production rise to 9.6 million barrels by April 2015. Global consumption is approximately 94 million barrels a day, growing at a rate of about 1 million barrels a day annually. We expect muted volatility to continue as the market struggles to assess the strength of demand and production flattens, again led by the U.S., which is now producing 8.8 million barrels per day. This production decline is offset by Iran returning to the market, growth in Iraq and the ability of Saudi Arabia to produce more, upsetting the supply and demand balance.

The low price of oil has been a key influencer for some of our economic recovery. Where is the optimal price per barrel in this environment, and what are the implications for being above or below that target?

Choosing an optimal price is always a difficult task but it would seem that a price in the $60 range would allow the producers to regain their financial strength, allow the oil service industry the chance to recover and would relieve consumers and industrial companies from distress related to higher prices.

Energy affects companies and their earnings that may otherwise appear to have little connection to transportation. Where are you seeing the biggest impacts?

The impact is widespread and touches many aspects of the economy across many different geographies. Industrial companies that sell either directly or indirectly into the energy complex have been hurt, banks that lend to the oil patch have suffered losses, millions of workers have been laid off and towns in North Dakota, Texas and other states have seen many businesses from restaurants to hotels to auto dealers suffer or fail.

Oil permeates the whole economy, and the effects are felt across our nation. Twenty-nine states produce oil in some capacity. While the impact on oil companies is evident, the land they drill is often leased to them by individual landowners who would have seen their royalty income slashed by well over 50%. Texas, North Dakota, California, Alaska, New Mexico and Oklahoma are the largest producers and may suffer disproportionally.

Over the last several years, alternative investment solutions have become more mainstream. One alternative strategy is the Master Limited Partnership (MLP), which is often associated with financing the energy infrastructure. The MLP space has seen dramatic shifts in the last year. What are you seeing in MLPs today and what do you expect to see moving forward?

The broad-based energy infrastructure growth engine has certainly changed. The energy infrastructure story is not over, but it has become niche-focused. Investors can no longer passively view this asset class, as the opportunity set has narrowed. Broadly speaking, the key growth production basins have adequate infrastructure; however, within some of those basins we see growth opportunities. We are also seeing infrastructure needs from the industries that use energy, from electric utilities to refineries, benefitting from the low price of energy. Longer-term, technological innovation by oil and gas producers cannot be discounted. Simply put, producers are able to produce more with less. The resource has been found and will be efficiently extracted, driving consistent demand for midstream infrastructure.

Many energy producers borrow money from capital markets in the form of debt. Has volatility in the market impacted their ability to do so? Has that changed with oil bouncing back over $40?

The ability to borrow money has been curtailed for energy companies. Along with the 130+ bankruptcies over the past two years, the exploration and production companies that pledge their reserves as collateral for bank loans have seen an average 25% cut to their borrowing bases in the past year. The ratings agencies have also downgraded the credit ratings of over 50 energy companies this year. That has not really changed with the rebound to the $40s, as it is a longer process and will benefit companies if prices remain at these levels or move higher throughout the year. What has saved many energy companies is the willingness of the equity markets to allow them to issue stock at a large discount over the past few years. Since the start of 2015, there have been at least 65 offerings raising $25 billion in capital for the industry.

As you think about potential outcomes over the next one to three years, where do you see oil prices normalizing?

The dynamics in the oil market appear to be different from any other time in history, making the range of outcomes nearly impossible to predict. However, though unlikely, excess supply could drive prices down toward $20. On the upside, there is a greater range of possible outcomes. Oil is produced in some very volatile places, and the elimination or disruption of some of those sources could cause prices to spike dramatically, possibly over $100. Again, that is a lower probability outcome but not impossible. We think global demand will continue to grow reasonably, supply should be muted — partially due to low prices over the past few years — and oil should trend into the $60 range over the course of the next year.

Assuming oil trades back to a $60 range, what would you estimate the potential upside across the energy complex over the intermediate term?

The stocks in this space have rebounded sharply off their February lows and currently reflect an oil price greater than the current market price. Depending on the energy sub-sector and the individual companies, we feel on average there is 40% upside as we move into the $60s on oil prices.

How is Westwood positioning the portfolio today across the energy complex as it relates to value and quality stocks with visible growth stories?

Westwood has focused on the companies with solid management and the best balance sheets, in the lowest cost, highest quality basin. We feel we are invested in the industry leaders that will not only survive this downturn but also thrive as we reach the other side of this nadir.

Oil and energy will continue to be a key element of our capital market performance here in the U.S. With this in mind, we will continue to look for investment implications and opportunities. Thank you for the trust you place in us each day.

 

 

 

 

For more information, please contact:

Dallas: Randy Root at 214.756.6980 or rroot@westwoodgroup.com

Omaha: Art Burtscher at 402.393.1300 or aburtscher@westwoodgroup.com

The information contained herein represents the views of Westwood Holdings Group, Inc. at a specific point in time and is based on information believed to be reliable. No representation or warranty is made concerning the accuracy or completeness of any data compiled herein. Any statements non-factual in nature constitute only current opinion, which is subject to change. Any statements concerning financial market trends are based on current market conditions, which will fluctuate. Past performance is not indicative of future results. All information provided herein is for informational purposes only and is not intended to be, and should not be interpreted as, an offer, solicitation, or recommendation to buy or sell or otherwise invest in any of the securities/sectors/countries that may be mentioned.