How Oil and Gas Companies Created Their Own Real Estate Bubble
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%.
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.