Monday, February 9, 2015

Capital Allocation Problem in the Oil and Gas Industry

There's a capital allocation problem in every company run by agents, but there's some reason to believe that the oil and gas industry is especially bad.

There are a total of 1,042 public companies in the Oil & Gas Exploration & Production industry (GICS:10102020). There are 429 with market capitalization between $5 million and $250 million. Of those, only 72 have positive retained earnings. Just under 17 percent.

Glenn Chan has figured out how oil and gas managements work. Read his posts: How would a sociopath fleece investors in oil and gas? and Why would anybody want to invest in independent oil and gas?. This is looking smart, too:

What makes things difficult for the honest E&Ps is that the dishonest E&Ps are raising lots of capital. Much of this capital is spent on drilling. This creates an oversupply situation that hurts the honest operators. The honest operators have to compete against irrational competition. As well, there is a shortage of honest management teams. The smart people often give in and play the game of selling overpriced stock like everybody else.

Eventually, there may be a situation where the shale boom turns into a bust. If that happens, it will be worth looking at the operators with integrity and unusual skill in being the low-cost producer. The old Contango Oil and Gas was such a company, but its talented CEO passed away. It may be worth looking at Southwestern, an old joint venture partner of Contango’s. However, you will need to wait for the day when silly shale stocks implode and end their irrational drilling.

7 comments:

James said...

There are a total of 1,042 public companies in the Oil & Gas Exploration & Production industry (GICS:10102020). There are 429 with market capitalization between $5 million and $250 million. Of those, only 72 have positive retained earnings. Just under 17 percent.


I looked at Goodrich as a short last year (regrettably, I didn't do it) and was amazed at how large their retained deficit was. It was something like 750mm then, and surely even more today.

CP said...

Yep!

Honestly, no one should ever invest in a company with negative retained earnings. Basic test of business model soundness and managerial competence.

Glenn Chan said...

Wow, I forget I wrote that!

Now that E&Ps have largely been slaughtered, it's time to move onto pharma...

CP said...

Still fair amount of E&P juice left, but... what do you see in pharma??

Glenn Chan said...

Lots of stock promotion in pharma and high valuations.

Some pharma companies have ridiculously silly business plans.

see my comments here: https://glennchan.wordpress.com/2014/12/26/year-in-review-2014/
"Bioturds are where it’s at"

High Plateau Drifter said...

The big problem for pharma is that we are only 5 to 7 years away from government price controls on new drugs under patent.

From a broad societal perspective this will be wonderful because this will stop the patent scamming with all of the "me too" drugs that might be 10% more effective than the one about to go off patent but that works on the same biological mechanism.

With lower prices per drug and less industry revenue, the biotech industry will have to concentrate on breakthrough drugs and especially those that work on new biological mechanisms.

More generics, fewer patent clones and more real innovation.

Even without Medicare Admin bargaining over reimbursements, the odds that the biotechs in the NASDAQ 100 (ALXN, AMGN, BIIB, CELG, GILD, REGN, and VRTX with PE ratios ranging from 40 to 150) could ever quadruple or quintuple their earnings to justify those lofty PEs with new drug discoveries is nill. They will be lucky to keep earnings flat over the next 10 to 15 years, and that is without govt price control.

The IBB, darling ETF of momentum investors is a screaming if somewhat cyclical short. It's long momentum phase is about over and it will disappoint for the next 10 years. Only a few companies within IBB will be able to identify acquire the few winners out of the 45 member biotech IPO class of 2014.

CP said...

http://www.creditbubblestocks.com/2015/02/high-plateau-drifter-on-pharma-bubble.html