Time to Buy Energy Producers: Part I

  • Oil Demand Shock: Covid19 has impacted oil demand consumption by approximately 20 million barrels a day, dropping demand down to 80m barrels a day. Some postulate that total impacted demand could drop by 30 million barrels as the virus spreads.
  • Oil Supply Shock: On top of the supply shock, Saudi Arabia’s fallout with Russia to coordinate cuts has now resulted in increased production as opposed to the planned cuts. The Kingdom of Saudi Arabia now plans to boost production to 10.6 million barrels per day from May onwards.    
  • An increase in supply as well as a decrease in demand has walloped oil prices and subsequently, the share prices of oil producers. Many of them are now priced as if they’re going to go bankrupt in the next 2-3 years with an EV/EBITDA of 3 or less. Since oil is still a critical component of modern civilization, and since no clean alternative to oil has been found, I find it ludicrous to think that it is not worth owning oil producing assets at these prices provided they pass some safety checks.

Price per barrel of crude tumbled from $61.06 at the beginning of the year.

Naturally, the share prices of most oil producers quickly followed suit.

Since we are nowhere near the invention of a technology that can yet replace oil and the burning of fossil fuel, the selling off here seems quite absurd.

Whilst oil producers certainly haven’t been good investments given the shale patch’s intrusion and subsequent reduction of barrel prices; it would be a mistake to price most oil producers as if they’re going bankrupt in the next 2-3 years.

Yes. I agree, if $20 per barrel is the new normal, most oil producers will go bankrupt.

But is $20 per barrel really the new normal?

I doubt it.

In summary, here are the 3 major reasons I am long oil as of now, March 20th, 2020.

First, supply destruction via covid19 virus cannot last forever. In other words, mean reversion.

Covid19 is a transient disease that will take time to run its course. But when it does, humanity will be there again, demand for oil now hotter than ever.

Second, oil price wars cannot last forever either. They can run for sustained periods of time, but they cannot last inevitably. At some point, they too need to end. Saudi Arabia needs $80/barrel prices to balance its national budget. Russia needs $40.

Third, future oil supply will be severely impacted by current cuts in production. Oil fields in America are not easy to get back online once shut off.

Some oil extraction areas are just uneconomical to get back online once you close them, stripper wells (less than 15 barrels of oil production or oil equivalent a day) are an example. HFI Research estimates that in the USA alone, a lack of completing wells will lose an approximate 750k barrels per day.

Shale oil, which contributed 68% of US total oil production in 2019 has primarily rapid decline rates. Yes. The graph is right. Peak production for US Shale is about 1 month into production for most shale wells. As a comparison, most mature oil fields decline at 5-7% annually, allowing oil outputs to stay steady for a much longer duration.

Source: EIA

Fourth, as I write this, there is increasing pressure among oil producers to close production. This is particularly so for the places without neighboring access to ports and terminal hubs – landlocked, with no where to go, oil prices are negative in some places -> producers are paying people to take away their oil.

Oil producers are also cutting back on capital expenditures to develop oil fields and decrease production, all of which are bullish for longer term oil prices once covid19 is gone for good.

But there are complications in this tight tangled mess.

The following are factors I consider in the selection of an oil producer to own.

Cost of production à Not all oil producers are built equally. Saudi Arabia and its neighboring regions have extremely low breakeven cost per barrel compared to the rest of the world (price of oil necessary to balance national deficit aside). In an environment of $20 oil, the lowest cost producers win. We should aim to own only the best producers with the lowest cost incurred per barrel of oil.

Goldman Sachs has also published a report recently on this. Here is an excerpt.

And yet, all of this above are just the cream on the cake.

Yes. Shutting in production is bullish oil long term. It means that when demand inevitably comes roaring back, supply won’t be in time to meet it and we’ll see a short period of high oil prices.

But what is truly important is the current price of oil.

As of today (10th April), oil prices are still untenably low despite a recent emergency opec+ meeting committing to cut oil production.

My whole thesis is predicated on mean reversion – that oil prices can stay low for some time but won’t stay SO low forever. So if you believe that oil prices cannot naturally be held down so hard for so long, than the natural course of action is to long oil – or oil producers if you want the leveraged upside.

There are 3 major things I’m looking for in oil producers as of now.

Hedging –> Oil producers hedge their production most of the time. Either with protective swaps or with cashless collars meant to introducer a floor and ceiling price to the product they sell. This restricts profitability to a range but allows them sell production at prices which are (hopefully) cashflow positive. If we should own an oil producer, we should look to own the ones with a management team that has proven itself in hedging out production faithfully and reducing downside risk to their business. 

Debt –> Most oil producers have too much debt. The reason most oil producers are priced for bankruptcy is because most of these oil companies (especially in the US) are at high risks of financial distress. Most have debt burdens they cannot pay off without substantial equity dilutive actions or without getting further into debt – something that might not be possible given the current banking bearish views on energy. And who could blame them? The energy sector for the past decade has been a blackhole of capital spending and lack of shareholder returns for most oil producers. If we should own such a company, low debt/an ability to refinance debt, an ability to meet all debt obligations should be a priority. You can’t ride the upside in oil prices if you aren’t alive to do it.

Valuations –> I hate quoting Warren Buffett, but I think he said it best in two simple sentences. If you have to think too hard about it, you’re doing it wrong. And if it doesn’t hit you over the head with a baseball bat, don’t buy. Or at least that’s the gist of what I got. I’m looking for a valuation so insanely cheap, it looks positively stupid to not get in.

So how am I playing this bullish view?

Enter Tethys Oil.

“Tethys Oil is a Swedish oil company with focus on onshore areas with known oil discoveries. The company’s core area is the Sultanate of Oman, where it holds interests in Blocks 3&4, Block 49 and Block 56. Tethys Oil has net working interest 2P reserves of 26.1 mmbo and net working interest 2C Contingent Resources of 13.5 mmbo and had an average oil production of 12,832 barrels per day from Blocks 3&4 during 2019. The company’s shares are listed on Nasdaq Stockholm (TETY).”

Here’s the quick numbers rundown. All information derived from annual report.

Share Price50.55SEK (Kroner, Swedish currency) / USD$5.05
Market CapUSD$192M / 1,924,973,456SEK
P/E Ratio4.46
Ev/Ebitda34,374,526shares x 50.20SEK = 1,725,601,205.2SEK, or, USD$171,070,201.93No debt+No minority interests -USD$75.6 in cash= USD$95,470,201.93 (enterprise value)   Divided by trailing 12 mths ebitda of USD$92.9M = Ev/Ebitda of 1.0276
Price to Cash Flow From Operations Per Share (USD)4.98USD (share price) : 2.64USD (per share) = 1.88
DebtThe Company has zero debt.  
Cost per barrel of oil (2020)2020 guidance of USD11.50 [average cost of production per barrel of oil in 2019 was $11.075]

From the annual report: “Tethys Oil’s (“the Company”) core area is onshore the Sultanate of Oman (“Oman”), where the Company holds a 30 percent non-operated interest in the exploration and production license for Blocks 3&4 (“Blocks 3&4”), a 20 percent non-operated interest in the exploration license for Block 56 (“Block 56”) and a 100 percent operated interest in the exploration license for Block 49 (“Block 49”). Tethys Oil also has non-operated interests onshore Lithuania via an associated company and in one license onshore France.”

Readers can ignore the licenses for block 56, 49, Lithuania and France for now. Those have not yet contributed significantly to the revenue of the company. Blocks 3&4 remain the core productive assets of the company and high levels of production in the range of 12,600 to 13,400 bopd (barrels of oil per day) are expected for 2020 (in comparison to 2019’s 12,832 bopd).

Block 49 is still under exploration, block 56 has not yet yielded results.

Let’s discount both blocks for now.

Focus on the cash flow of oil production from blocks 3&4.

2019-year end results were based on an average selling price per barrel, USD of $61.4.

Complicating the math, the licenses to explore and produce in the blocks of Oman are all held under EPSA (Exploration and Production Sharing Agreements). The agreement allows Tethys oil and operating partners to first recover operating expenses and capital expenditures from revenue. If you exceed 40% of revenue during a period, you can bring forward the unused balance.

The remaining 60% is split 80% Oman government, 20% Tethys and partners.

Sounds troublesome? I agree. It is.

What this basically amounts to is that a percentage of the oil sales price is recognizable as earnings to Tethys Oil while the company still bears operating expenses.

But let’s put that aside and look at the math.

I’ve modelled various oil sales prices of $30, $40, $50, $60, $70 to give us a clearer look at what kind of earnings, and hence what kind of valuations we can be expecting moving forward.

Using very rough numbers, we can approximate Tethys Oil to be free cash flow positive at $35 per barrel and above. Also, a notable point is that every $1 change in average per barrel price achieved results in approximately $919,800 of free cash flow. Note that this goes both ways.

Management Alignment à Magnus Nordin

Magnus Nordin has been the managing director since 2004. Since 2019 annual report is not out yet, I’ve used the company’s website displaying ownership structure.

What is significant to me is that even if we take 2018’s annual reported shares held count of 1,467,127 shares, that records Magnus Nordin’s stake in the company at an approximate USD$740,899.135. A third of a million. In comparison, Magnus Nordin’s compensation yearly was USD$47,040. That’s nearly 15 times his yearly compensation including long term incentive plans. So, I have ample room to believe that Magnus Nordin’s alignment is at least in the same direction as shareholders.

Management’s recent decision to axe dividends downwards while taking this chance to do mandatory share redemptions support my view that they are shareholder accretive, or at least, not working to enrich themselves vs the investors.

In Summary

  • Low cost of oil production provides Tethys oil with significant upside to higher realized oil sales prices
  • No debt allows Tethys Oil to lever up should they need to in an environment where interest rates are basically rock bottom.
  • Call option on future ability to find more oil production -> Company has 100% operating interests in Block 49 and 20% interests in Blocks 56. Block 49 is still pure exploration. Block 56 is undergoing testing of its drilled wells. In either case, I view their ownership in this areas as a free call option. Should significant discoveries be made, the company will be able to skyrocket total barrels produced over the future term and this should result in quite the gusher of cash. If nothing develops, we acquired the company at a cheap enough price that it doesn’t really matter. What we should watch out for is if management begins to start drilling recklessly. Much investment capital has been destroyed in this manner and is what makes energy a sector investors have learned to avoid as management teams put $1 into the ground to get $0.50 back out instead of the other way around. Having said that, I do not believe Magnus Nordin would willingly do this to himself. In 2018, his shares were worth nearly 20 times the value of his compensation (SEK80-100 vs the SEK50 now). He would likely want to see it back up there.
  • Management Alignment  à Magnus Nordin’s stake is 15x his yearly compensation.
  • Production & Reserves à Company has 1P (proven reserves) of 17,336 million barrels of oil left as of 2019. Given current run rates of oil production, the company has 4 more years of oil production left to go. Yet the company is priced at an EV/EBITDA of 1.0276, implying the company is not worth much more than a year of earnings. As we have reviewed, that is patently false.
  • Risks à Naturally, significant risks are present. Perhaps most salient, is that oil prices can suffer significantly in the extent of an extended virus/economic downturn

Disclaimer: I am not vested as of the writing of this article but will look to acquire a sizable allocation (for my portfolio) over the next 1-3 months.

Some further notes;

  • I am no oil expert. Information I’ve gathered has been from the web and further readings.
  • I get things wrong. I might get the future oil thesis of supply/demand imbalances wrong – don’t come crying to me if I’m wrong.
  • I am not a certified professional analyst. I’m a retail investor. I don’t run a hedge fund. I’m young (gf disagrees, body too for that matter), and I’m doing my best to get things right. But I do get things wrong too. If you catch something, just let me know. Even better. Do your own work.

All criticisms and questions welcome.

3 thoughts on “Time to Buy Energy Producers: Part I”

  1. Did you read about IMO 2020, the sulphur regulations? How do you think this will impact oil prices as well as market sentiment towards end 2020/early 2021?


    1. Hi Jeng. Yes, I did. I currently hold $EURN, $STNG and $TNK as part of my investment thesis in imo2020. Covid19 has derailed the impact somewhat and in my view pushed it out to 2020 2H or even 2021. The consequences aren’t well known and no one can claim to know the exactsies.

      As for how it’ll affect oil prices -> not that much. IMO2020 has been a known regulation for many years and all it did was jack up fuel prices for shipping companies. That’s why scrubber equipped eco-ships were good investments since they earned greater premiums and could burn the same old cheaper fuel.

      I don’t really know how market sentiment will turn out and I prefer not to try and pinpoint it. No real value there.


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