The oil industry is in the midst of a downturn, with the stocks of U.S. exploration and production (E&P) companies largely underperforming the broad U.S. stock market. While the industry copes with a current volatility as well as the massive shifts on the supply side brought on by horizontal drilling and hydraulic fracturing, or fracking, investors have largely walked away. But the need for oil will continue as global demand increases, especially from emerging markets.
So, what should investors do?
Understand the changing economics of the industry. Identify individual companies that have realigned their corporate strategy to the structural shift in the industry.
And be patient.
Yesterday’s Oil Industry
Prior to the shale revolution, the market’s concern was peak oil and reserve replacement. Companies would access ever more challenging reservoirs in a drive to capture “dwindling” resources.
Companies created value by buying land cheaply and—with teams of geologists and some luck—struck oil. Companies constantly had to find new resources as the inventory of future well locations was relatively limited.
Reining in spending wasn’t an issue because of the pressure to find new reserves. In fact, E&P companies routinely outspent their operating cash flows. Rising oil prices only helped to reinforce the sense of urgency to bring on new supplies.
Today’s Oil Industry
As the industry has moved from resource scarcity to resource abundance with the advent of shale, energy companies are being forced to change their business model. For example, they can no longer spend 100 percent—or more—of their cash flows.