Sunday, August 23, 2015

Analysis of Diversified Portfolios: CHK, ECA, UPL, and WPX

If there is one sector of the economy laden with mousetraps with balls of sour cheese, that sector right now would be the energy industry. Cheap oil prices have pervaded the speculation of traders looking to send their money into the energy sector. Looking back at the last earnings period reveals a massive sell-off of companies that used to be some of the most profitable in the entire stock market. Now, decreasing revenue and razor thin margins have been demolished by cheap crude oil prices. That was a month ago when oil prices still drifted around $50. Ten dollars lower, $40 futures contract endanger the ability to hedge against low prices that could be below operating costs. This article will be focused on energy companies that show the potential to survive in the slump. Because the overall trend is so far bearish, an inevitable uptrend can be an easy road to profits if the right stock is chosen. We'll be looking at some cheap investments (share price under $10) by analyzing performance and projections given in the 2015 Q2 report as well as some statistics that have been tracked for the past year. The companies I will be looking into are listed below:

  • Chesapeake Energy (CHK) 6.87
  • Encana Corp (ECA) 6.32
  • Ultra Petroleum Corp (UPL) 6.63
  • WPX Energy Inc (WPX) 6.68
These companies are four domestic oil and gas services with significant plays in the major basins around the country. All are part of the XNG natural gas index ticker as well as being priced under $7. The theme of this small "case study" is value hidden in cheap prices. Looking at the market price for these companies reveals that they might not have much value in them, but downward pressure from low oil prices deceptively hides the potential for growth. Making a good wager is about speculation supported by evidence and analysis. Trade with reason. I chose these companies to analyze because of their large investments in natural gas. It is my opinion that energy companies with diversified assets will be the winners coming out of the slump. Hence, I feel that cheap potential could be hidden in these stocks. My opinion is not unique as the lowest average volume over three months among the companies is above 2.7 million (UPL). The highest average is 23 million (CHK).

I could introduce each company with what they do and where they operate, but the story is the same for each company. They are exploration, acquisition, marketing, and transportation services that have portfolios consisting of crude oil, natural gas, and natural gas liquids. Most of the wells are concentrated in Texas, Wyoming, and a few in the Appalachian basins, but for the most part, their assets are spread out across the country eventually trading at the WTI price at Cushing, OK. Just as their operations are relatively similar so is the size and value of each company. CHK and ECA are the largest with their market cap topping $4 billion and $5 billion respectively with over 3,000 employees. UPL and WPX are smaller barely topping $1 billion in market cap and 160 and 1,500 employees respectively. CHK and ECA are a little bit more established with more assets that could assist in liquidation when needed, but for the most part, each company hovers around the mid-cap size.

Mid-cap stocks have the best potential for growth because they are big enough to survive the slump but small enough to have substantial room for growth. Hence, UPL and WPX would be a riskier bet overall as they might not have the liquidation ability needed to sustain capital intensive operations. At the same time, inchoate companies might be prone to large amounts of debt that can be dangerous in an oil price slump as interest accumulates and cash flow is low. In that case, acquisitions and mergers might be the panacea which typically results in a large increase in that specific stock. We will expect larger companies to have the ability to lower costs efficiently, but their hefty nature forces major capital commitments for large scale changes and innovations that need to be instituted across operations. UPL and WPX will be a little more versatile and most likely to adopt technological and infrastructure changed in their small-scale projects in order to preserve their position in the market, but they will be most hurt by the reduction in revenue. In the end, the reduction of revenue will hurt everyone, but what sets companies apart is how they handle that. Here, I could repeat revenue losses for each stock and try to discuss which company has been the most successful in slowing the bleeding, but I won't because every sales total has been hurt in a manner proportional to the scale of their operations. All energy companies have experienced losses, but the value is found instead in the price of those sales, profit margins, and how companies are going about production as the slump continues. How much are investors paying for the revenues that are maintained? For this, we will look at how much investors must pay for every dollar of sales and every dollar of book value. 

First, price-to-to sales ratio reveals similarities between the four companies. A trailing average over the past year of the ratio is below 1.00 for three of the stocks with UPL being the most expensive at 1.04. Investors should be encouraged by this as the new fracking revolution has enabled revenue growth to be cheaper with significant cuts in costs per well. CHK reported 30% reduction in well costs in Oklahoma as they continue to drill deeper and refine lateral methods. In that region, 2015 well costs were $300,000 cheaper than the 2014 averages after one-quarter. At the same time, their southern division continues to increase costs (up to $8.0 million) in order to increase production and reach. ECA has been successful in cutting costs as well reporting a $1.0 million reduction in well costs down 18% from last year. Although, some expensive wells in the Duvernay region are costing up to $10.4 million for completion of deep wells in order to increase production. UPL's higher price-to-sales ratio could be the result of wells that are predicted to pump losses this year. Depending on reserve size, $3.2 million wells (which are relatively cheap) have expected rates of returns ranging from 38-94%. WPX, with the second highest price-to-sales ratio, has reported a 16% drop in operating expenses, but it the quarter briefing also informed investors of divestitures in natural gas plays. Overall, it seems a bit obvious that the most established companies are more successful in dropping costs due to their capital network and experience. On the other hand, CHK's deeper and more expensive projects seem out of place in the slump. Yes, I agree more production is good, but building the most expensive wells amidst poor market conditions can hurt margins especially when hedging high prices is almost impossible. UPL and WRX have shown financial discipline by focusing on drilling cheaper and in a shorter amount of time. Because of their versatility their drill completion times are less than half of CHK and ECA's at 11.6 and 7.9 days respectively. An amazing thing happens when we look at price margin where the smaller companies have the advantage.

The numbers above are a result of the acute effects of new fracking technology. The two companies with larger market cap and span of operations are experincing negative profit margins as they rush to cut costs plays that have been drilled conventionally. Capital investments will hurt the initial round of drilling, but will slowly lose its negative effect as a massive new infrastructure pumps oil and gas efficiently. UPL and WRX have already had the advantage of installing efficient production on a smaller scale. Many microeconomics economists might argue that larger operations have the capital and the know-how to reduce costs, and that will certainly help CHK and ECA in the long run, but smaller companies have the necessity and the economic adroitness advantage. What investors are paying for during low oil prices is value. The pricetag on value can be determined by a price-to-book value ratio. This is represented by the orange bar in the second chart and mostly equal except for UPL. CHK and ECA are relatively cheap because of their establishment as a business. Investors that put their money in those stocks are paying for growth and revenue. WPX is an odd case because of their recent move to liquidate natural gas investments to prepare for an acquisition. Their value is a little inflated because they have less assets that are being speculated as cheaper; therefore, portfolio solidarity is a litttled harder to discern. UPL is the odd ball of the bunch with a price-to-book ratio almost five times that of its counterparts. A higher ratio is usually the result of larger liabilities like debt. Because UPL was started in 2011, it still has financials that reflect a start-up. Small market-cap with a tendency to have growing debt and large capital expenditures can spell weakness for an investor looking to ride out a shock. In its Q2 report, UPL reported a $500 million program to expand capital expenditure by drilling 111 new wells. Major spending programs like this can hurt profit margins and will sacrifice income for growth in the future but can be fatal to business operations during periods of low crude oil price. Traders might be especially wary as UPL's total cash smount of $5 million is heavily outweighed by its $3.43 billion debt.

Besides financials, the most relevant analysis will come from an overview of a company's production statistics. Production data explains how a company makes its money, where it is growing, and which source has become a key ingredient in a successful portfolio. For the energy companies listed, there are three main components of production: crude oil, natural gas, and natural gas liquid. A first glance at the chart above highlights the differences between market cap and company size. CHK and ECA with the higher market cap have operations that more than double the production levels of UPL and WPX. This may be advantageous in maintaining higher revenue, but operations that large can be overreaching in times of low margins. Like Hitler's Operation Barbarossa in the Russian winter, overstretched assets can deteriorate under tough conditions. CHK reported new lateral wells that will cost significantly more to drill which could damage marginal profits in the short-run, but the quarterly report also informed investors of a 500 MMcf reduction in natural gas extraction attempting to offset those potential losing margins by cutting production costs. Sometimes producing as much as you can is not the dominating strategy as market conditions might incentivize other behavior. There is a time to develop capital intensive infrastructure, and there is a time to focus on margins. The winners will know when to do which. After reading UPL's production reports, I admire their efforts to focus on cheap drilling in order to maintain their desirable profit margins. While they might not have the most impressive pumping predictions, their assets will most likely be worth the most relative to the wells that did the extraction. I see them maintaining the safest revenue levels as the slump continues. ECA, in my opinion, has also been able to secure relevant cash flow but more through hedging than through cost efficiency.For their portfolio of oil and gas, they successfully hedged their oil at $61.95 and their natural gas at $4.29 in Q2. Both hedging prices are at least 20% higher than NYMEX futures prices at that time. What's even more tantalizing for investors looking for a solid stock is that ECA has also secured substantial price hedges at $62.83 for 2016. Their performance on the futures market beats CHK (oil at $97.91 and gas at $1.01), UPL (no oil hedge and gas at $3.50), and WPX (oil at $49.64 and gas at $2.40) making them look like a safer bet for income recovery as they continue to cut costs and boost production. Perhaps they can make a move for some more market share as other forms fail in hedging. Where ECA looks a little undesirable is their attempt to reduce natural gas production for more crude oil extraction. Quarterly releases repeat the statistic that their oil production has increased 87% while natural gas went down 38%. WPX reported the same kind of statistic with substantial increases in oil investments alongside divestitures in natural gas (but for a different reason). CHK and UPL reported increases across the board: +11% oil, +11% natural gas, and +24% NGLs for CHK and an overall 15% increase in natural gas and oil for UPL. During the oil slump, it is crucial to find and augment portfolio assets that show the best outlook for growth, and investments in crude oil production look extremely bearish currently. ECA and WPX will feel the effects of the oil glut longer as much of the recovery in energy prices will be demand based affecting natural gas and NGL prices as well. Natural gas especially looks like a smart investment as coal is being forced out of the energy market by climate change based policy from President Obama. There is too much bad sentiment surrounding the oil industry which makes WPX's acquisition a wager upon the recovery of oil prices in the near future. A lot of the financials reported by WPX reflected their attempts to establish solidarity in order to push their acquisition of an oil company operating out of the Permian Basin. WPX divestitures in natural gas were instituted in order to boost cash reserves and EBITDAX (EBITDA without exploration costs) to solidify their financial position to the outside world. Trading this stock long-term could be a justified bet on a company operating with successful profit margins but creating vulnerabilities with less diversification and more oil production. The addition of more oil assets is especially frightening in the face of a poor hedging performance where 2015 oil has sold at an average price that is below $50. But with the most potential for growth, I predict WPX to be the most volatile stock of the four as the acquisition negotiations continue. Large movements could occur by the end of the year for a stock that has a beta just 20% higher than the market average (and pretty much equal to CHK's and ECA's). CHK seems like a pretty safe bet to survive the oil slump as its extensive production miasma will consistently bring in revenue as long as the WTI price (or hedged price) stays high enough to offset costs of more capital expenditure. It's low beta (1.13) and diversification for such a low share price makes it a cheap security for investors looking to retain returns of about 10% (±3%) over a year depending on where the energy markets move in the coming twelve months. Because ECA is making a bigger move towards oil, I would typically be cautious with this stock, but their hedging performance, coupled with their established market cap, enables me to be a little more positive about their outlook. Given the current market conditions, I'd like to see an 8.5% gain on their stock price in a year with a lower bound at 7.5% and an upper at 10%. The smaller range of growth can be attributed to their rigid position in oil price due to hedges in 2016 that could be upstaged by WTI growth above that level. UPL and WPX are the wagers among the four oil services as their sizes lend themselves to higher volatility in the next year. UPL's value is rather expensive compared to the older companies to which I have compared it. Investors are paying for a high level of debt that will hopefully be offset by high-profit margins and shrinking drilling times. As long as UPL stays committed to this, they can create solid financials out of the slump and wrestle away market share from other energy companies lagging behind. A 20% growth rate over a year sounds reasonable given their potential to stay competitive, but if the market stays significantly oversupplied, growth could be stemmed to 10% or worse if debt catches up with them (3.5-5%). Mergers and acquisitions always provide opportunities for investors to score windfall profits. WPX's acquisition of oil plays in the Permian can be dangerously expensive and unaffordable if not hedged correctly. Projections for stock growth in the next year could be anywhere within a range of -2% to 30%. A play for more oil during a recovery could turn out to be brilliant on the executives who will be credited for the windfall profits. On the other hand, the looming danger of low prices can render an acquisition too obese for a mid-cap company with decreasing revenue. 

What do these numbers say about the industry as a whole? Oil and gas will experience deflationary pressures for awhile. Speculation a year ahead of the current drop to $40 predicts a minor recovery topping off at $50. Companies will be losing money for the rest of 2015 and must look forward to cutting costs and pumping the cheapest oil they can for the time being. Pressure on natural gas prices should be released earlier than that on crude oil. Hence, I chose these companies to model those that will have the best chance of growth after the slump. The name of the financial game has always been diversification and margins. Nothing has changed. 

Thank you for reading my analysis in four oil and gas services looking to make it out of the slump. I left out technical analysis for the sake of length, but I would be more than willing to take a look at the CHK, ECA, UPL, and WPX charts if interest is shown. Just contact me personally or on Twitter, Facebook, or Stocktwits to let me know.

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