How We’ll Profit From the Next Round of Oil Deals
Recently, following my keynote address at an energy conference in Houston, I had an interesting discussion with one particularly knowledgeable global oil trader. The subject was financing the next wave of international operations and/or mergers and acquisitions (M&A).
Both of us had been tracking the changes in how project funding was made available. The revisions in where funding was coming from have been as much a reaction to accelerating debt costs as they have been to the stubborn lowering of crude oil prices.
We’ve discussed the deteriorating debt problem in Oil & Energy Investor before. With West Texas Intermediate (WTI, the benchmark traded in New York) prices north of $70-75 a barrel, the traditional practice of rolling forward debt used for operating expenses had been the normal process for many U.S. companies.
These days, with WTI prices at less than $45 and Dated Brent (the London benchmark more widely used in worldwide oil trading) hovering at $50, all bets are off.
There’s a wrinkle emerging that may provide us with some flexibility moving forward. Remember, we don’t need oil prices to rise to $70 or above to make money from the coming wave of M&A. The trick is to identify those companies likely to benefit from the revision in funding structures.
And here’s how we’re going to pinpoint these profit opportunities…
Increasing Demand for Oil Will Have to Be Met
As I’ve discussed before, the cost of new debt (if companies can even acquire it) is becoming prohibitive.
Debt costs are the fastest rising reason for a new cycle of M&A.
Aside from the state producers in the leaders of OPEC (Saudi Arabia, Kuwait, and the United Arab Emirates), few companies anywhere on Earth can finance the next round of projects with petty cash.
But given that global demand is still rising and production will be needed, where is the money going to be sourced?
Subdued market prices, surplus production, and the Chinese situation are all being lauded as the reasons for supply-side concerns. But on the other side, demand is not declining. In fact, and despite some volatility in numbers, both the OPEC Secretariat in Vienna and the International Energy Agency (IEA) in Paris are pointing toward record global daily demand by the end of this year.
That means, regardless of what price per barrel is being set in New York and London, refineries (the primary end user of crude oil) will still need guaranteed volume flows. Some companies will survive the current malaise and even register profits… but they still need to finance forward projects.
The new financing arrangements taking form amount to a twist on what used to be the primary way solvent international companies would finance most of their future projects. Recall that until recently credit lines were the main financing instrument. But that would not always mean floating junk bonds at unsavory double-digit interest, as most companies face these days.
Rather, the process would usually go something like this. An experienced company with a track record of successful projects would secure a line from a lead bank. The bank would then syndicate that credit with other banks to lower the individual institution’s exposure to risk.
How Oil and Gas Operations Are Being Funded
These days, however, the way this is done is changing and with it the prospects of making money from the companies benefiting.
In the older version that we widely used until a few years ago, banks and producers that had successful previous experience together would iron out an agreement with both sides discounting the transaction.
The company would deliberately underestimate the proved reserves they had available in the ground while the bank would deliberately underestimate what the market would pay for it. The resulting credit line would be used to fund the project.
In a more or less stable environment, the discounted volume on one side combined with the discounted market value on the other would guarantee a profit margin for both company and bank(s).
This came to an end once the world entered into the credit crunch of 2009-2011. With banks no longer lending to each other, the syndication approach could not work. If a lead bank chose to fund a project anyway, it would be carrying the risk alone. That risk quickly translated into interest rates simply too high for any company to accept.
How We’ll Profit From the New Financing System
Today, on the other hand, this process is returning, albeit it with an important difference.
Syndications are now becoming an alternative way for companies to value productive assets and secure credit based on them. This is as likely these days to be funding for general operating expenses as it is for a specific future project.
But it nonetheless allows us to do something quite important when it comes to identifying oil and gas companies in which to invest. It comes down to this:
Those companies having assets that can be collateralized (not subject to sale) will be able to access funding at more affordable rates by using the syndication approach. Therefore, those able to withstand the volatility of the market and its price swings will be those that can avoid floating junk bonds.
These are the survivors as well as targets for M&A resulting in profit for stockholders.
Either way, knowing who can use production, fields, and leases as collateral will translate into a list of operators that are going to provide returns to average retail investors.
This is where profits will be made. I’ll keep you updated as investment opportunities arise.