How Oil and Gas Companies Created Their Own Real Estate Bubble

Matthew Carr By Matthew Carr, Emerging Trends Strategist

Oil & Gas

We are a nation built on debt.

Americans take on debt to buy a home. They take on debt to buy a car. They use debt for everyday purchases with a credit card.

When I was first starting out, I received all kinds of advice on how to be successful. One piece of advice, which I received from a very wealthy individual, was to live slightly beyond my means… no matter what. He argued that the constant overhang of financial burdens would mean I’d never get comfortable or complacent.

Now, I don’t contest that logic. But it’s a slippery slope from “slightly beyond your means” to “completely underwater.”

So, I didn’t follow that advice. Instead, I did the opposite. I carried as little debt as possible – and paid it off as quickly as I could.

Why? As we saw with the Great Recession, the economic landscape can change very rapidly and financial futures can change overnight – but debt is still due.

Many Americans have learned that lesson the hard way. But companies and industries still struggle with it.

In July of last year, the Energy Information Administration (EIA) released a warning on the energy industry and its growing debt. That was before crude prices buckled and collapsed.

At the time, the EIA stated, “Cash flow from operations for major energy companies has flattened in line with flat crude prices, which have had the lowest price volatility in years…”

I highlight that line because this EIA research was published on July 29, 2014. That was right when global oil prices began to unravel.

This mentality was reminiscent of the one prevalent in the real estate market almost a decade ago… the belief that there would never be a price collapse. During the Great Recession, real estate investors took on a ton of debt because they thought they’d receive a return on that investment. They didn’t.

Now, the same thing is happening in the oil and gas industry.

In the July 2014 report, cash flow from operations of 127 oil and gas companies totaled $568 billion. But expenses totaled $677 billion. The difference was met with a combination of increased debt and asset sales.

In 2010, the difference between cash flow from operations and expenses was $18 billion… so just slightly beyond companies’ means.

Over the next three years, that gap surged to $100 billion to $120 billion.

Everything was still fine in the first quarter of 2012. Debt repayment as a part of U.S. onshore producers’ operating cash flow was just over 40%.

ERDchartcashflow
Then, the unthinkable happened. The crude market turned.

By the third quarter of 2014, as the price of crude began its tumble, debt repayment accounted for 60% of operating cash flow. By the fourth quarter, it was 70%. And as of the second quarter of 2015, it accounted for 83% of operating cash flow.

That’s $0.83 of every dollar from operating cash flow going to debt.

This is the flaw I saw in the “always live slightly beyond my means” advice. If the economic landscape is rattled, the weight of that debt increases exponentially.

So instead of being able to take advantage of opportunities, you end up trapped.

When the price of crude imploded, mergers and acquisitions (M&A) should have picked up. Low oil prices caused many oil and gas companies to take huge hits, making them ideal targets for larger companies to scoop up. Yet globally, the total number of deals in the oil and gas space is down more than 40% year-to-date compared to 2014. That’s a 10-year low.

But the amount spent in M&A this year is up by more than $15 billion globally.

The thing is, two acquisitions – the Royal Dutch Shell (NYSE: RDS) and BG Group (OTC: BRGYY) $81.5 billion deal and the Energy Transfer Equity (NYSE: ETE) and Williams Companies (NYSE: WMB) $70.6 billion deal – account for nearly half of that dollar total.

Here’s the situation: Oil companies are essentially real estate companies. Instead of building homes or apartments or shopping malls on the land they own, they pull resources from it.

Now, many oil and gas companies will use credit facilities to meet their short-term cash needs. Their reserves – or “real estate holdings” – are used as collateral. Twice per year, these credit facilities undergo redeterminations. They’re revalued.

With the price of crude cut in half, this means the collateral of oil and gas companies is essentially worth 50% less. That means less borrowing power and an uphill climb to cover expenses and liabilities.

And with prices failing to stabilize, what was supposed to be a boon year for M&A activity is hamstrung.

Oil and gas companies fell into the same trap that hurt so many during the Great Recession. The expectations that the price of oil would continue to inch higher created a situation where taking on increased debt was of little consequence.

The real estate industry learned its lesson. And now, so has oil and gas.

With M&A activity expected to ramp up when prices recover, look for bargains in the sector that have solid fundamentals. Like a homebuyer during the Great Recession, you may find yourself a quality bargain.

Good investing,

Matthew

  • William Dunn

    So, for those of us who are fast approaching retirement age and feel the need to balance our portfolios, are we to forgo bonds entirely?

  • I think Marc’s comparison of Muni Bond vs Dividend paying stock (ADI)is excellent and timely. Too many financial authors are willing to “throw the baby out with the bathwater”!

    Kim Benner

  • timothyjhealy

    No argument with the notion that muni yield levels after five year maturity provide little value protection in a rising interest rate scenario. Keep in mind, however, that muni interest exemption emanates from a two hundred year old Supreme Court opinion “McCullogh vs. Maryland” not some legislative action.This is also the reason that federally issued obligations are exempt from local taxation.
    Also KIM that muni bond proceeds are spent by politicians in lieu of raising taxes.

  • Min

    Compare those two can see clearly of the result. I still think MLPs and Healthcare REITs are better investment for retirement long-term plan. Even JNJ, KO, KMB… can do better job. I might be wrong, for now I will still stay tune and watch about tax issue closely. Patient and having plan B are the keys for these days.
    Thanks for offering good example. M.

  • Chris johnson

    I have a number of MLP’s and I need to know more about them, such as what happens after the company has repaid 100 pct of your initial investment in distributions. Also, when the stock is gifted or passed to a beneficiary, is the basis changed? Thanks, chris

  • Joanna Kim-Selby

    Currently riterees are paying taxes on muni bonds. Those muni bonds are calculated in when we calculating our social security benefit some pay 85% some 50% of their benefits for tax. Also we reach our medicare all included in again paying extra medicare fees.

    If the politicians want to charge fees interests whatever it nothing new. It has been done some years back.
    I think it has been practed for over 20 years.

    Joanna Kim-Selby

  • r.dinoi

    never trust a stock broker… they would sell teir mother! my mother used to say. You look to be the first one to start to effect this belief of mine: keep up the good work, wherever you a re making your money, good luck!
    signed:
    a senior searching for an income on lifetime savings.

  • JeanMayer

    All is well if you can compound, like leaving it an IRA, and the income is nontaxable until withdrawn. But what about someone like me that can’t add to their IRA. I have to pay taxes up front and that comes out of my income. So it looks to me like the $2673 would have been taxed about $1160 dollars (43.4% x 2673) which would leave me with $1510 not $2673. In which case the MuniBonds would be a better deal unless they start including them in taxable income. Please tell me where my thinking is wrong if you disagree.

    • Stan

      I had the same thought about the effect of taxes on the dividends, but the last line before the chart states that this analysis is “The totals in the table below are net of taxes.”, which I take to meam that the dividends are actually much higher and that the 2,673 is what’s left over after taxes have been paid.

  • TexasStud66

    Check Out (LPI) Laredo Pet. ($13.50) a Barrel Costs of Production. Hedged at $77.- $81 a Barrel Thru 2017. [350 MM barrels of Proven Reserves in Permian Basin. 3RD QTR. Report due on Nov. 3RD 2015. Possible Buyout candidate.

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