E&P Vulnerability, Defensiveness & Valuation Post Downdraft
TD Investment Conclusion
Yesterday marked a horrific day for energy producers and energy investors, with the average name within our coverage group shedding >30% of its market cap in a single day, and some faring much worse.
In our view, the current WTI oil price weakness is directly attributed to a combination of what should prove to be temporary events - specifically fears (and ebbing oil demand) surrounding COVID-19 and the Saudi/Russian dispute that resulted in Saudi materially dropping its official selling price (link) and potentially starting to flood the market in April (during what is likely to be a weak period for demand due to COVID-19). Although these issues are likely to be resolved in the coming quarters, in our view, the longer they persist, the more challenged some producers will become. In this note, we look at:
Debt Leverage Timelines [Exhibit 1]:
If you ultimately share our view that crude oil prices improve from current levels, it is paramount to select equities that are able to survive long enough to see this price improvement. In Exhibit 1, we provide a heat-map that outlines how we expect corporate leverage ratios to deteriorate under a strip pricing scenario (absent capex cuts, dividend reductions, asset sales). Notably, there are a handful of companies that will retain significant balance sheet flexibility even under a strip pricing scenario (PSK, EOG, PXD, COG, FRU, TVE, CXO, TOU, ARX, PDCE, ERF). Alternatively, approximately one-third of our coverage is on track to see strip D/CF metrics balloon above 5x by YE-2020. While interest charges are likely to be covered, this could in some cases result in covenant breaches or liquidity challenges.
Required WTI Prices to Cover Base Operations [Exhibit 2]:
Many of the companies within our coverage group have significant hedges in place to protect CF. On average (including forecast hedging gains), our coverage group requires only US$15/bbl to cover cash expenses. Excluding hedges, this is ~US$22/ bbl. However, on average, WTI of US$44-US$47/bbl (including/excluding hedges) is required to cover cash expenses and sustain current production. It should come as little surprise that those which can maintain their businesses on the lowest WTI prices also largely have the most defensive balance sheets (as highlighted above).
Implied WTI Prices Currently Being Reflected in E&P Equities [Exhibit 3]:
Finally, under current strip pricing, it is challenging to find deep-value in the E&P space. For example, the Canadian Integrated producers trade at ~11x EV/EBITDA, the mid caps trade at 5.5x, and the juniors at 8x. In all cases, these valuations are notably higher than their trailing one-year average. In our view, equities in our coverage group are discounting ~US$46/bbl WTI. Although this is higher than current strip pricing, it is materially below the >US$60/bbl we saw just six weeks ago