The Walking Dead?

At 453.6 million barrels, U.S. crude oil inventories remain near levels not seen for this time of year in at least the last 80 years. – Summary of Weekly Petroleum Data for the Week Ending August 7, 2015

The oil & gas energy complex is nearing a state of panic, if it isn’t already in one.

We’ve been talking about the glut of energy resource supply for many months now, and our impeccable positioning in the newsletter portfolios long before the collapse in prices is well known. Kinder Morgan (KMI) had been a relative outperformer in the Dividend Growth Newsletter portfolio until we removed it at $40 per share a couple of months ago. The same had been true with Chevron (CVX), and the recent exit of Energy Transfer Partners (ETP), a difficult decision, leaves us only with the Energy Select Sector SPDR (XLE) as our sole exposure to the oil & gas arena.

We’re still not sleeping well at night.

OPEC is in a no-holds-barred pricing war, and it is our contention that the cartel’s sole intention is to put independent oil & gas plays out of business in the US to drive prices back to “equilibrium.” OPEC is not ceding market share at all, and we don’t think the cartel will back down at any cost. US independents are playing a game of “Russian roulette” with the organization, and frankly, given OPEC’s massive reserve base, the cartel holds all the cards. US independents are no match. The current dynamic is much different than in previous energy cycles in which OPEC sought price stability, letting others scoop up incremental market share.

This week, crude oil prices reached their lowest levels since the depth of the Great Recession in March 2009, and we don’t expect them to find a bottom for some time yet. This view is not new “news.” We’ve been warning about the ongoing drop at $90, $80, $70, $60, $50, and now we’re warning at near $40 per barrel. Many investors continue to be bullish on the energy sector as a whole. Maybe a recency bias leads them to believe that a return to $100 per barrel crude oil is going to happen? Many executive teams are budgeting $70 per barrel crude oil pricing for 2015. We’re not kidding.

The rolling of our valuation models a number of months ago uncovered an energy complex that is in need of tremendous debt issuance in 2016 and beyond if energy resource pricing does not recover, and such a view considers the substantial capital expenditure cuts across the space. Importantly, our valuations on exploration & production entities also consider a “return to normalcy” in energy resource pricing in arriving at an estimate of their intrinsic value, but it is growing more and more likely that the low end of our fair value ranges across the upstream space are more accurate. The ongoing losses on energy debt paper thus far during the pricing collapse, and the “blown-out” spreads on energy debt suggest that default rates across the energy space may surge in coming years.

Investors should be concerned. It has been 80 years since we’ve had crude oil inventories this high at this time of the year in the US – not since the 1930s! According to an August 11 report from Bloomberg, “OPEC pumped the most crude (oil) last month in more than three years as Iran restored output to the highest level since international sanctions were strengthened in 2012.” The lifting of economic sanctions on Iran may only have a marginal impact, but in the case of pricing a commodity, the marginal price is the only price. We’re not witnessing a meaningful slowdown in US field production of crude oil either. On the basis of data from the EIA, for example, US fields are producing at a pace not seen since before 1983, the earliest data point that shown!

By our estimates, US field production levels are currently double those in late 2008, when crude oil prices were about the same as those today. With OPEC’s production raging on and China’s economy slowing down (and the collapse in the country’s equity market not yet completely felt), the real price of a marginal barrel of oil may be far below today’s levels. Investors should be fully aware that it has only been 17 years since the price of crude oil was $12 per barrel.

Interesting that the Dow Jones dropped 500 points on August 31st that year (a 6%+ drop), a huge sell-off that wiped out gains for the year. And just like the six-year bull market extending through today, investors at that time were wondering “if the unprecedented bull market of the 90s (had) finally met its end.” Investors soon learned later that it had, with March 2000 marking the infamous peak of the dot-com craze. Signs continue to point to less risk-taking, not more.

If crude oil prices end up falling to the levels of the late 1990s (~$12 per barrel), upstream equities will be in a world of hurt, even if many of them do inevitably survive. In doing our duty, we’ve scoured the global universe of oil & gas upstream equities to uncover those with debt-to-equity ratios that made us squirm in our seats. Though we view debt-to-equity as an inferior measure of leverage, the availability of more advanced credit metrics across companies we don’t cover is limited.

Fairly, the list is not complete by any stretch of the imagination, and some equities are certainly better off than others, but readers should certainly be cognizant of the severe risks of holding overleveraged upstream equities that are burning through cash (negative free cash flow) and levered to the spot market for energy resource pricing.