Oil Prices Will Break $100 Again, Sooner Than You Think

The 2020 Pandemic devastated the U.S. oil industry.

As the world went into lockdown, demand for oil products — particularly fuels — died. Oil prices plummeted, as you can see in this chart of West Texas Intermediate (WTI):

That short blip in oil prices devastated an already reeling industry. Fourteen companies filed for bankruptcies of more than $1 billion each in 2020. To put that in perspective, there were only 54 in the prior six years. Three companies: Chesapeake Energy, Ultra Petroleum, and Unit Corporation filed for bankruptcy with more than $5 billion in debt, each.

Since 2015, oil companies that held $175 billion in debt filed for bankruptcy.

That’s a problem for the industry for two reasons… first is that drilling shale wells requires capital. With so much debt reduced by bankruptcies, few lenders are willing to take that risk. And with the heightened climate change awareness and negative sentiment towards fossil fuels, few lenders have an appetite for oil today. Without debt, oil companies must fund drill programs from cash flow. But low oil prices mean cash is tight.

That means the U.S. will get far fewer shale wells drilled in the next couple of years than in the past.

New wells matter, because the second part of this equation is that shale wells produce most of their oil in the first 18 to 24 months after completion. To keep U.S. production the same, we need a lot more wells, which won't come. Fewer wells mean falling oil production. There’s no doubt that the U.S. oil production is on the decline. And the peak for U.S. production was 2019.

You can see that reflected in the U.S. Energy Information Administration (EIA) U.S. Crude Oil Production forecast chart:

The chart shows that from 2020 to 2022, the annual average production will be well below 2019. And it will decline from 2020 to 2021. I expect the decline curve to be steeper than the EIA’s chart, due to the cash flow problems we discussed.

Less oil from the U.S. oil fields means less oil supply for the world… supply will fall.

What About Oil Demand?

Demand for oil climbed as lockdowns ended. The travel industry saw a massive decline in spending in 2020, down 42% from 2019.

However, with lockdowns ending, people have been flying again. According to the Transportation Security Administration (TSA), 35 million people passed through TSA checkpoints in March 2020. That was just under half the total from 2019. By April 2020, only 3.2 million flew. That’s just 5% of the 2019 total. That crushed fuel sales.

Now, with widespread vaccinations, the numbers went up instead of down. Demand for jet fuel climbed. And it’s the same with cars.

Travel and trade account for an enormous amount of oil demand. As you can see in the EIA forecast below, demand should meet or exceed 2019 by 2022:

The takeaway is that supply is falling and demand is rising. That math equals higher prices. And while we haven’t seen demand kick in yet, oil prices are already over $80 per barrel. That suggests a $100 price target is reasonable as demand rises.

For investors, that means there’s a huge opportunity in oil companies today.

Here’s How to Play the Surge to $100 Oil

The smart way to play rising oil prices is through the three main parts of the oil industry: oil service, exploration/production (E&P), and midstream. Each of these sub-sectors has value today. However, each one brings its own risks too.

We can use a simple real estate comparison to understand the oil industry. E&P companies are the developers — they figure out where to put the houses and they design the subdivision. The service companies are the builders. They swing the hammers and dig the ditches to make the houses. Midstream companies build the roads and run the pipes and electricity to the development.

If there’s a housing boom, we want to own the whole sector. The same goes with oil. Each of those groups adds value and profits from rising oil prices. Right now, we can get both stock price upside and lock in excellent dividend yields in some of these companies.

That makes the oil industry doubly attractive right now.

Oil Service Companies

There are many of these companies that make up the “picks and shovels” of the oil industry. Most of them are either drilling companies, specialty services companies, or engineering companies. However, there are three that stand out: Schlumberger (NYSE: SLB), Halliburton (NYSE: HAL), and Baker Hughes (NYSE: BKR).

All three companies are strong operators that will continue to play a key role in the oil industry both in the U.S. and abroad.

A quick review of their fundamentals shows that each company has a strength and a weakness. For example, while Baker Hughes has almost no debt, at just $3.5 billion, it only generates about 2% free cash flow per quarter from revenue. The other two carry much more debt but generate much more free cash flow. Baker Hughes and Schlumberger also pay a 3% and 2% dividend yield, respectively. Halliburton pays less than 1%.

Any one of those three companies will do well as oil demand climbs.

E&P Companies

These companies went bankrupt in droves over the last few years. The shale boom from 2010 to 2014 lured many management teams to make huge bets that required sustained high oil prices. When the price corrected from 2015 to 2016, a wave of bankruptcies hit. Then survivors piled cash into buying distressed assets. They expected oil prices to rise, which they did until 2019. Then the pandemic hit, and oil prices collapsed. It spurred another massive round of bankruptcies.

As we said earlier, companies wiped out over $175 billion in borrowed money by going bankrupt. Much of that went into expensive shale wells. That’s why we need to be careful with this group of companies. Some are still struggling to turn a profit.

Fundamentally, we want to see companies that have low debt and can generate free cash flow at these low oil prices.

Of these three, Cimarex is the only one that we can own with confidence. However, Matador Resources achieved positive free cash flow in the fourth quarter of 2020. They used the extra cash to begin paying down their debt. Matador had an excellent first quarter 2021 and a record second quarter 2021.

These companies carry much more price risk than service or midstream companies. That’s because the oil price directly affects their revenue. Invest accordingly.

Midstream Companies

Midstream is a fancy way to talk about storage and pipeline companies. These are the businesses that move oil and gas from point A to point B. They do some cleaning and storage too. The good news is that most of their revenue doesn’t change with the whims of the oil price. But they get hurt when their clients go bankrupt, so they will move with the oil sector.

An uncomplicated way to break down these investments is to ignore any company without free cash flow for the last 12 months. This metric doesn’t work for all the groups, it’s an excellent tool for cutting down possible integrated companies to invest in. We want these companies to be capital efficient and generate free cash flows to pay our dividends.

That cuts out many of the major oil companies (which is why they aren’t on our list). And it highlights some excellent opportunities for investors to make money. We can do that by looking for companies that trade under 10 times free cash flow.

For example, giant Ovintiv made $152 million in free cash flow over the past 12 months. But its market cap is $6.6 billion. That means we are paying about 41.5 times free cash flow. That’s too high for us to expect a big gain.

The median price to free cash flow is about 22.5 times. We want to see room for growth. At 41.5 times free cash flow, Ovintiv’s shares need to decline in price for it to hit the median metric. That’s not good. We want to see companies whose share price needs to rise to get to that point. And there are several worth looking at. Below are three midstream oil companies that offer us great investment opportunities, based on that price-to-free-cash-flow metric:

These companies trade for 6.3 times, 8.0 times, and 8.1 times free cash flows, respectively. That means they all need to at least double just to get to the median price-to-free-cash-flow metric. But more importantly, all three pay large dividends. In a zero-percent world, even a 6% yield is outstanding. And as you can see, two of the three companies pay double-digit dividend yields.

That’s an outstanding investment idea — buy a company that trades well below the industry median in P/FCF, pays a big dividend, in a sector that’s going up. You can buy any one (or all three) of these companies and should do well over the next 12 to 24 months.

Conclusion

I hope you see the simple case for rising oil prices and take advantage of the opportunity it represents. Many investors avoid the oil sector today because it is out of favor. That makes it even more profitable to folks who understand and prepare for rising oil prices. If you still drive an oil-powered vehicle — boat, car, motorcycle or even a lawnmower, you understand that it isn’t going away anytime soon.

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