Portfolio manager says large cap producers coming to the fore as industry changes because of extraction and operational changes
Major consolidation is on the way in the oil space that will cause investors to rethink their approach to the industry.
Steve Bonnyman, portfolio manager and co-head of North American Research at AGF Investments Inc, believes the nature of the energy sector is changing because of several reasons.
Firstly, because geology is no longer the major constraint it was 15 years ago. He told WP that the goal of discovering a new field and diving into it has less attraction for producers than the extraction from existing fields.
Secondly, on an operational level, the process has evolved because of the drive towards increasing productivity and lower operating costs, resulting in an industrialisation of the extraction process and a higher level of operational complexity. This lends itself to larger, more sophisticated players compared to the smaller companies.
Bonnyman said: “Operators are drilling longer lateral wells. They are going vertical and then turning 90 degrees and going out over two miles. They need bigger land packages to be able to do these multi-mile wells. Putting multiple companies together to create large packages is very attractive.”
For investors, these developments require a more disciplined approach. They must understand why they are investing in the oil space and what they hope to achieve, as well as undertaking a rigorous analysis of the opportunities and risks in each case they are looking at.
“If one is only there for broad exposure to energy, that would bias you towards the majors where they have the complexity, structure and capital," Bonnyman said. "If one is seeking to participate in the consolidation side, you have to be a little more disciplined about understanding the land packages and skill sets that are embedded there and how that fits as part of the puzzle with another player.”
Bonnyman believes oil is a good place to be right now but accepted there are factors acting in opposition to this view. The market is tight and OPEC requires higher fiscal bundles that steers them towards constraints and support for higher prices, while US producers are moving from capital consumption to shareholder returns where the market is demanding dividends, share buybacks and actual return of capital. This, naturally, constrains their production profile.
He said: “Our belief is that the rate of growth in the US continental shale oil has probably peaked and, while it will continue to grow, it will not be at the rate we’ve seen.
“The other side is that the market remains very thematically concerned about demand, both short and long term. In the near term, the risk are of a global recession and trade wars taking place, Longer term, thematic news revolves around the growth of renewables and my belief is that the markets are overstating the ability of renewables to grow and materially displace the existing demand base for fossil fuels. That should be added with the term ‘sadly’ because it would be nice if they could do more from an environmental standpoint.”
So how do you pick a good large cap oil producer? Bonnyman said investors should look at their production rate of gas versus oil. Is it Brent, WTI, heavy or light because that will reflect on price realisations. They should also be concerned as to whether the operation is off or onshore as that will indicate what the demand for capital will be to maintain production rates.
Canada has a disproportionate level of noise around its producers as it struggles to move product to market, making the US a more attractive place to be. Investors, Bonnyman said, therefore need to embrace more elements when deciding how and where to deploy their money.
He said: “At the risk of telling them to spend as much time as we do on it, they need to think a lot about the nature of the natural-gas-versus-oil ratio in the production stream, so they truly understand the revenue component.
“Secondly, understand the company’s ability to move that product and get it to market, so they have egress on pipeline access. Lastly, where does [the company] fit in the cost structure because that will not only impact their operational ability and affect their cash flow but it will also weigh on whether they will be attractive as a consolidator or as something that will be consolidated.”