Saturday, October 20, 2007

A Typical Energy Cycle

The Energy Sector is inherently cyclical and a typical cycle moves in this fashion (beginning at the top):

1. Companies are flush with cash due to great pricing, and/or high commodity prices. Earnings and price momentum is also superb, and everyone is happy. Most companies can't decide what to do with the excess cash - dividends, stock buybacks?

2. Customers begin letting rig contracts roll over as high day rates and service costs cause exploration to be less economical. Smart money starts to exit positions, while the economy weakens a little bit and demand for the commodity drops due to high prices.

3. Rig utilization and day rate declines start to show up in official reports as capital budgets of customers are cut back due to a further drop in commodity price, possibly due to an unexpected dip in demand. Smaller Exploration and Production companies cut back almost immediately as cash flow decreases. The larger independents swear that they will "drill through the downturn." Integrated oil companies adopt a wait and see attitude due to more diversified cash flows, secure balance sheets, and a more disciplined capital program. Stock prices begin to flatten and even decline in some cases.

4. Sell side begins marketing push to prop up stock prices in the sector during conference season, claiming that "valuations are compelling."

5. Stock prices weaken materially as the sell side begins to cut earnings estimates and commodity price assumptions.

6. Extra supply of oil or natural gas hits the market due to the high level of drilling activity in the preceding 12-24 months. Commodity price weakens further, leading to another round of estimate cuts. Stock prices “fall off the cliff.”

7. Sell side throws the towel in on the sector.

8. Utilization and day rates plunge as contracts rollover and are renewed at lower rates or not at all. Industry starts “cold stacking” rigs. Majors begin cutting capex budgets.

9. Commodity prices bottom and industry bumps along the bottom for six to twelve months as malaise sets in over industry. Drilling falls to an all time low. Late cycle companies (international and construction) see earnings peak.

10. Commodity prices begin to strengthen as demand recovers and little supply is added due to a lack of drilling.

11. Rigs begin to be put back to work again as cash flow improves. Day rates and utilization inches up.

12. Debate erupts as sell side breaks into two opposing camps: (1) Time to invest or (2) Is it too early?

13. Cycle is in full upswing as more rigs are put back to work which leads to increasing day rates for drillers and pricing power by service companies. Commodity prices strengthen further.

14. Majors begin to announce increases in capex budgets.

15. Companies start to beat earnings estimates, and momentum money gets into the stocks.

16. “Boom” mentality takes over in the industry. First articles are circulated claiming “we are running out of oil and/or natural gas.” Alternative energy companies begin to get a lot of press and attention.

17. Federal government announces “Energy Policy.”

18. Go to number 1.

So the two questions I have are - Where are we now in the cycle? And is it different this time?


Anonymous said...

You have to overlay this cycle with the super cycle in commodities that started circa 1900. My view is that 1982-2000 was a correction on this cycle, and that now this super cycle has resumed. Since the current oil cycle and the super cycle are currently synchronized, the oil cycle will have more duration and peak higher than the previous cycle which took place during a correction of the super cycle.

Eric J. Fox said...

You may be right about that. Tell me more about this super cycle? I don't think I have heard about this.