Investors are fond of noting that most of the people who made money out of the great California Gold Rush in 1849 were not the prospectors – few of whom found enough gold to make themselves rich – but the people who sold them picks and shovels.
The old saw has been dusted off in recent years by those wary about investing in producers of shale oil from North American fields, and the recent drop in the oil price – which reached a five-year trough below $50/bbl in January – is adding weight to their words. For many investors, production companies look unattractive, but this makes energy infrastructure providers look all the more enticing.
“When you have a business that is declining by 70% every year, that’s a pretty tough racket,” says Tim Gramatovich, CIO of Santa Barbara-based high-yield specialist Peritus Asset Management.
This is the average decline in annual production from shale oil wells, he says. As a result, companies constantly have to spend huge amounts of capital to find new sources of production.
The point is echoed by Roberto Cominotto, manager of the JB Energy Transition fund at Swiss & Global Asset Management. Because of this constant expensive search for the new wells, he says that, for each dollar of cashflow generated, many companies have to spend two dollars on capex.
“With oil prices at their current low level, for some of them past levels of spending will not be possible anymore,” he says.
Lower oil prices reduce the cashflow needed to fund a high proportion of the capex, but also make it harder for producers to secure the financing needed to fund the rest of it. In short, lower oil prices have made the shaky economics of much shale oil production even shakier.
Looking at North American shale production as a whole, the effect of lower oil prices will be dramatic. Over the past two years, North American oil production has grown by an annual average of about 1.2m bbl, says Cominotto. By contrast, for this coming year “it is difficult to estimate whether it will grow at all”.
Sceptics might wonder why the businesses providing infrastructure to ailing shale oil producers should be any more attractive than their troubled clients. After all, when California’s gold finally ran out there was no longer much money to be made in selling picks and shovels. However, investors argue that pipeline companies – the favoured infrastructure providers for many investors – are insensitive to the ebbs and flows of oil production. Their revenue comes from long-term contracts that demand payment for a certain regular volume of energy in advance, regardless of whether the energy company actually uses all of this capacity. In other words, the risk of low volume is not borne at all by the pipeline company.
This obligation to pay is, naturally, not entirely protected from a shale oil bust – even if oil producers are legally required to pay for pipeline capacity, if they go bust there will not be money left to honour take or pay contracts. But investors downplay the this dangers for pipeline companies, for two reasons.
In the first place, even if the shale oil industry falls into severe trouble, these companies will be protected by the large amount of their revenue that comes from transporting natural gas. This commodity is enjoying its own production boom thanks to the shale revolution, and in North America the economics of natural gas are much more stable than those of oil.
In the US, the price of natural gas has been pretty much flat for the past three years, notes Michael Roomberg, analyst at Miller/Howard Investments in Woodstock, New York. “By fostering demand, this creates enviable growth opportunities for pipeline companies specialising in natural gas, such as Kinder Morgan, Williams Partners and Energy Transfer Equity”, he says.
In the second place, the pipeline companies benefit from the fact that there is not enough pipeline capacity in the right places, now that much of North America’s oil and gas production is in locations, such as North Dakota, where production was previously low or non-existent.
Long-term, pipeline companies may also benefit from the energy revolution in Mexico – the government has ambitious plans to increase oil and gas production by opening fields to private producers. In 2014, El Paso Natural Gas Co, an affiliate of Kinder Morgan Energy Partners, expanded its natural gas pipeline capacity connected to Mexico.
But however attractive their business models are, pipeline companies will only be attractive to investors if they can be bought at the right price.
Investors say that, because of the strong reaction in equity markets to the fall in the oil price, many have become good bargains. Gramatovich of Peritus likes Crestwood Midstream Partners, the US natural gas transportation company that in mid-December was down 29% on the year, at $16.13. “It has been crushed along with everything else that says energy on it,” he observes.
The bond market offers similar bargains.
“The fall in oil prices has affected the perceived credit quality of the lower-rated issuers,” says Ron Daigle, senior credit analyst at Hermes Credit. “But a lot of the analysis is done in a relatively static environment – people are just knocking down the prices and not giving credit to management for taking actions such as cutting capital or operating expenditure.”
Because of this, he argues that there are still selective opportunities in high yield. He cites MarkWest Energy, a US pipeline company yielding 5.2% in mid-December for 2023 paper – up from 4.6% on the eve of the November Opec meeting where the decision not to cut production sent oil prices plunging.
Investors also show interest in infrastructure companies outside the pipeline sector, if they hold an extremely strong market position. For example, Cominotto’s JB Energy Transition fund holds Newalta, a Canadian wastewater management company serving oil producers, which is benefiting from stricter environmental regulations.
The fall in oil prices has certainly made energy infrastructure companies all the more attractive, by improving their investment metrics. However, at some point the price rout of shale producers themselves will become so bad that these companies will seem even more attractive.
Cominotto at Swiss & Global thinks that point has already come. His fund has recently invested in a small number of producers, including Canada’s Cardinal Energy, which recently bought oil and gas shale interests in Texas. Following a recent fall in the stock price, it offers a dividend yield of 6.1%.
“We are targeting companies which have the lowest production costs in the industry, strong balance sheets, and very strong economics even at the current oil price,” he reveals.
Timely and judicious investment in the prospectors should always be considered, even if the sellers of picks and shovels remain better bets for much of the time.