Introduction to my investment philosophy and methodology. Petroleum Producing Industry Overview. Top companies in this industry by the numbers. Conclusions. Introduction: investment philosophy and methodology I want to begin by explaining a little about my investment philosophy: My focus is to add income when it is cheap enough. In other words, I like to determine the ideal yield I would accept from a stock as my target for entering a new position. I rely on my patience that took some time and age to develop. A good example that illustrates these principles, if you are interested, is a recent article that I wrote about XOM. If you are not familiar with how I analyze companies and industries please consider my age-old favorite, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do. I have made one primary adjustment from that earlier set of rules regarding the debt to total capital ratio. While I remain very cautious regarding free cash flow and companies' ability to service and repay debt if the economy experiences another financial crisis, which I still believe is very possible, I place an emphasis on debt levels relative to a company's industry peers. But I have adjusted my calculation to be more in line with traditional convention and now use the total of debt plus equity to represent total capital. It is easier to understand and there is really very little difference from my earlier method, so the variance is of little consequence. Petroleum Producing Industry Overview I know what you must be thinking. This looks like an attempt to put lipstick on a pig! Bear with me and you will realize that I am doing nothing of the sort. For the last year this industry has been wallowing in the mud, stinking up the place and doing a very good impression of a pig, but without lipstick. But that is the past. We need to look at the future. Uh-oh. Well, the near future does not look very good either. In other words, even the leaders in this industry will require patience to find a good entry point. But that will come and then the potential of the best companies will be worth a good hard look. So, today we are doing a little homework to prepare us for establishing a good rising income stream. So, why am I writing about this industry now? The simple answer is that I hope to give my readers a little insight into what patience can do for portfolio returns. We may not be able to pick the exact bottom, but we certainly can avoid the pain of entering before the worst is behind us. I expect more downside here and I want my readers to take the proper precautions when considering a beaten down company. It could get beaten down even more and give us a REAL bargain! Those companies that are able to adapt to lower prices will consolidate and grow. As many readers who are familiar with my work know, I once expected the price of oil to remain elevated. That was before the widespread adoption of hydraulic fracturing in the U.S. oil and gas industries. Now that there seems to be an abundance of oil and natural gas it seems more likely that prices will remain tamer with a lower ceiling that was the case prior to 2011. How technology changes our lives and our investment thesis. If you would like to understand more about my view on oil and natural gas prices in the short, intermediate and long terms, please refer to my three article series, Energy Sector Outlook. At the same time, many older producing fields are still experiencing declines in production. Technology has brought some new life into gathering more oil from wells and fields that were previously considered uneconomical. But the application of that technology also depends heavily on the price of oil remaining north of $60 or $80 per barrel, depending on where the reserves are located. Here is what I said in 2012 in an earlier article: "So, if demand falls enough to cause the price of oil to drop below the magic number for too long, wells will be capped, production will be reduced and exploration drilling will come to a halt in high-cost areas. The result will be an equilibrium between demand and supply that props the price of a barrel of oil back up high enough to reopen wells and restart projects that had been shut down. But the equilibrium won't happen overnight. We would fist need to suffer through much higher prices for a period deemed long enough to make capital investment seem less risky. Our comfort is not the subject of what determines optimal pricing; profit is the goal. It always has been and always will be." Admittedly, I had it backwards back then. First we will have to endure lower prices until an equilibrium between demand and supply is reached. Then prices may edge higher if demand can outpace supply. As I point out in the Energy Sector Outlook articles, the abundance of supply and known reserves yet to be developed should hold prices below the $100 mark for the next five years or more, or at least during most of that time. There is always the potential for wild swings due to geopolitical and major weather events, but those are generally temporary in nature. When the price of oil get much above $70 I expect supply to begin to flow as wells that have been shut in or drilled but not yet completed will be brought into production if that price level can be locked in using hedging strategies. I also think that many companies in the industry have learned the lesson about balancing greed and hedging this time. Let us hope! Top Companies by the numbers Even with that introduction, I need to add a few more words of caution. This list does not constitute a recommendation to buy any of these companies at current prices. I believe we will get a better opportunity to buy these assets after the waves of bankruptcies get up a head of steam (again covered in depth in the article linked above). Also, please understand that I generally only update industry analysis once a year so all data (except price, dividend and yield which are current) are taken from year-end, audited financial reports. Now, having set this up to be based upon the numbers, I really have to explain that this industry (or any other industry when it is as distressed to this extent) will look horrible by the numbers. What we are trying to do is find the best "future" picks that we will focus on when the time is appropriate, add them to our list, and wait for a better entry point. With that in mind, the factors that matter the most to me right now are those that will enable a company to survive the worst conditions (and I expect things to get even worse by year-end), then play a role in consolidating the best assets, and rise like a phoenix when the worst is over. To that end, I will be placing more emphasis on cash flow management, balance sheet strength, net margins (the least worst) and asset quality. The last one is subjective and ties into net margins because the companies that have the lowest cost of production will generally have better net margins and that usually results from higher quality assets. Production costs are costs to operate and maintain the Company's wells, related equipment, and supporting facilities, including the cost of labor, well service and repair, location maintenance, power and fuel, gathering, processing, transportation, other taxes, and production-related general and administrative costs. The companies are not exactly fully transparent regarding the respective lifting costs (the cost to extract a resource out of the ground once drilling and well completion have been done). I only found this figure broken out in two instances. Thus, to make things comparable, I calculated production cost using the above definition which I found in the latest annual report of Anadarko Petroleum (NYSE:APC). By calculating it the same for each company we have a better gauge of how each one compares to its peers. One last adjustment to my normal assessment; I used the four-year compounded average growth rate in EPS instead of the five-year. The reason I did so is that 2009 would have been year one and the industry was in shambles then, too, due to the financial crisis and because having a negative number in year one really skews the rate. Apache Corporation (NYSE:APA) has exploration and production (E&P) operations in the U.S., Canada, Australia, Argentina, Egypt and the North Sea. The company produces natural gas (32% of 2011 oil equivalent production), oil and natural gas liquids [NGLs]. APA is well-positioned in terms of reserves and capacity to increase production to meet future demand. In 2014 APA produced 218.3 million barrels of oil and NGLs; 651,109 million cubic feet (Mmcf) of natural gas. Revenue broke down as 49 percent from oil and 51 percent from natural gas. It reported reserved at the end of 2014 at: 1,147 million barrels of oil and NGLs; 8.4 Tcf of natural gas. APA has a good habit of acquiring reserve assets from other struggling companies in the industry when asset prices are reasonable. However, it has over paid in recent years just like everyone else in the industry. Over the long term, though, I like this company's buy low, develop and sell higher strategy. Management appears to be cutting costs in an attempt to sustain profitability in a low oil price environment. It may have a difficult time while the price of oil is much below $40, but should prosper with prices above $50. Apache's cost of production is $17.21 per barrel of oil equivalent [BOE]. Among the pure E&P companies I reviewed this is the lowest cost of production. Let's look at the metrics. Metric APA Industry Average Grade Dividend Yield 2.1% 1.1% Pass Debt-to-Capital Ratio 32.3% 36.2% Pass Payout Ratio NMF 24.5% Fail 5-Yr Ave. Annual Div. Incr. 10.8% 10.2% Pass Free Cash Flow -$10.81 N/A Fail Net Profit Margin NMF 14.9% Fail 4-Yr Ave. Annual Growth - EPS NMF 1.7% Fail Return on Total Capital NMF 6.5% Fail 5-Yr Ave. Annual Growth - Rev. 7.5% 7.4% Pass S&P Credit Rating BBB+ N/A Pass Since I base the numbers and ratios on annual data (because the annual statements are audited whereas quarterly are not), we need to take into account the asset write downs and how these amounts may affect future earnings potential. APA had over $5 billion in asset write downs and impairments in 2014, which caused EPS to be negative. The number would be only slightly positive and down from 2013 if we remove these non-cash expenses. Apache looks terrible from a purely pass/fail aspect; five passes and five fails. Where you see NMF it means not meaningful and designates that the number was a ratio above 100 percent. Three of those ratios are so large because of the non-cash expenses. The average annual growth in EPS is also attributable primarily to the non-cash expenses but would still be negative. This company has been a perennial leader in its industry and will probably recover to earn back that mantle again in the future. It is one we need to watch carefully to see how well it adapts to the lower cost environment before considering an investment. I am a long-term owner of ConocoPhillips (NYSE:COP). COP has E&P operations in nearly 30 countries around the globe. The company had 8.9 billion barrels of oil equivalent in proven reserves at the end of 2014. Total production in 2014 averaged over 1.5 million BOE per day. While COP has produced well over 1 billion BOE since 2011 its reserves have increased meaning it is more than replacing reserves. That bodes well for the long term and since COP will be well positioned to benefit from the coming consolidation, I expect reserves to rise faster in the next two years. Production costs in 2014 were $20.87/BOE. Let's see how COP fared against the metrics. Metric COP Industry Average Grade Dividend Yield 5.9% 1.1% Pass Debt-to-Capital Ratio 32.5% 36.2% Pass Payout Ratio 57.0% 24.5% Fail 5-Yr Ave. Annual Div. Incr. 6.6% 10.2% Fail Free Cash Flow -$2.09 N/A Neutral Net Profit Margin 11.8% 14.9% Neutral 4-Yr Ave. Annual Growth - EPS -4.3% 1.7% Fail Return on Total Capital 8.8% 6.5% Pass 5-Yr Ave. Annual Growth - Rev. -15.7% 7.4% Fail S&P Credit Rating A N/A Pass Only four pass, two neutral and four fail ratings. The same old story of write downs and impairments will run throughout the industry. COP is no different and there will be more through at least year-end. COP is cutting capital spending, like most others in the industry, to enable management to uphold its pledge to continue increasing its dividend. I like the commitment to return capital to shareholders in the form of dividends. But the share price has more downside to come before things get better, in my opinion. The company is canceling deep water drilling efforts in the Gulf of Mexico for the time being and will pay a hefty cancellation penalty on a drilling rig contract, probably in the third quarter. The current year is going to be difficult for COP. But the company and its management are worth considering after it has worked through these difficult adjustments. It will benefit from being able to acquire low cost assets and reserves as the industry consolidates. The next company I considered is Marathon Oil (NYSE:MRO). Like COP, MRO split its operations and spun off the downstream assets into a stand-alone company. The timing seemed right at the time with oil prices elevated; now, not so much. Reserves were about 2.2 billion BOE (as of December 31, 2014) and daily production in 2014 amounted to 285,000 barrels of oil and 808 Mcf of natural gas. Aggressive cost cutting initiatives are the focus of management, including capital spending. But more will need to be done to return to profitability as long as the price of oil remains so low. Production costs in 2014 were $22.63/BOE. Metric MRO Industry Average Grade Dividend Yield 4.7% 1.1% Pass Debt-to-Capital Ratio 23.3% 36.2% Pass Payout Ratio 56.0% 24.5% Fail 5-Yr Ave. Annual Div. Incr. 7.3% 10.2% Fail Free Cash Flow -$2.01 N/A Neutral Net Profit Margin 8.9% 14.9% Fail 3-Yr Ave. Annual Growth - EPS -15.9% 1.7% Fail Return on Total Capital 4.2% 6.5% Fail 5-Yr Ave. Annual Growth -Rev. -9.5 7.4% Fail S&P Credit Rating BBB N/A Pass Marathon achieved only three pass ratings along with one neutral and six fails. I like the yield but either of the preceding companies is likely to outperform MRO over the long term. But we need to watch how the various management teams react to the lower pricing environment before we pass final judgment. Anadarko Petroleum is another well run behemoth in the oil patch. It is suffering the same fate as its peers, though. APC has another problem in the short term: the Supreme Court ruled against APC in the 2010 Macondo oil spill incident in the Gulf of Mexico. That could leave the company liable for up to $1 billion in civil suits. The good news for prospective investors is that it will probably get worse before it gets better. But the company has some excellent reserves around the world it is determined to hold onto for long-term development. Proved reserves at the end of 2014 were 2.86 billion BOE, but APC is one the best companies at increasing reserves having a five-year average reserve replacement ratio of over 600 percent. Daily production in 2014: 126.3 million barrels of oil and NGLs; 1.356 Bcf of natural gas. Production costs in 2014 were $21.08/BOE. Metric APC Industry Average Grade Dividend Yield 1.4% 1.1% Pass Debt-to-Capital Ratio 45.7% 36.2% Neutral Payout Ratio 47.0% 24.5% Fail 5-Yr Ave. Annual Div. Incr. 24.6% 10.2% Pass Free Cash Flow -$9.38 N/A Fail Net Profit Margin 5.9% 14.9% Fail 4-Yr Ave. Annual Growth - EPS 8.8% 1.7% Pass Return on Total Capital 3.9% 6.5% Fail 5-Yr Ave. Annual Growth - Rev. 14.8% 7.4% Pass S&P Credit Rating BBB N/A Pass Five pass ratings is the best so far; with one neutral and four fails. This is still not a stellar report card by any stretch of the imagination. The company has much yet to do but, like the others mentioned above, will survive due to its size and its ability to adapt. Adapting to the environment is crucial for survival in this industry. APC has some great assets and will sell some of the less desirable assets to preserve its future developmental potential. We need to keep an eye on this one to see if it can make the adjustments necessary to weather this storm. The last company I want to keep a close eye on is Canadian Natural Resources (NYSE:CNQ). The share price has already dropped over 50 percent from its 2014 high, but there should still be some more downside as the industry continues to get beaten down by falling oil prices. Proven reserves work out to be 4.5 billion barrels of liquids; 6 Tcf of natural gas. Daily 2014 production: 531 million barrels of liquids and 1.55 Bcf of natural gas. The average production costs are a little higher for CNQ at $29.47/BOE, but still not outlandish. Controlling costs and reining in capital expenses will be the test that management needs to master, as is the case across the board in this industry. But, thus far, CNQ has performed better in many ways than its peers. Metric CNQ Industry Average Grade Dividend Yield 3.9% 1.1% Pass Debt-to-Capital Ratio 31.5% 36.2% Pass Payout Ratio 25% 24.5% Pass 5-Yr Ave. Annual Div. Incr. 25.1% 10.2% Pass Free Cash Flow -$1.39 N/A Neutral Net Profit Margin 17.9% 14.9% Pass 4-Yr Ave. Annual Growth - EPS 10.1% 1.7% Pass Return on Total Capital 9.7% 6.5% Pass 5-Yr Ave. Annual Growth - Rev. 13.8% 7.4% Pass S&P Credit Rating BBB+ N/A Pass Holy cow! Nine pass ratings and one neutral. By far the best of the group and a very big surprise to me. But that is a measurement of the past performance. The dividend increases will likely slow significantly for the next two years, but should then be above the industry average again. The yield is strong and debt is under control. Cash flow is not negative by much and can be improved with reductions in capital investments and operational cost cutting. The company will struggle to make a profit in 2015 but could be well positioned for a rebound sometime in 2016, depending on what happens to energy prices between now and then. I will hold off investing in this one until we find a bottom in the price of oil and the bankruptcy announcements begin to taper off. Even then I will want to take another look to confirm whether management has been up to the task. I plan to write focus articles to provide more in depth analysis on each of these companies as oil prices find a bottom the supply/demand imbalance shows stronger signs of correcting. As for those other companies that did not make the list, I will remind readers that I do not include a company unless it pays a dividend or if it cuts its dividend, and I also do not include companies that have unsustainable negative free cash flow. These two exclusionary conditions were present in nearly every other company in the industry that I follow. I also do not follow companies that are not listed on U.S. exchanges with consistent trading volume liquidity. As companies in this industry adapt to the lower pricing environment I will try to review each and add it to the list. At the present time, the companies listed above are the ones I expect to survive and potentially provide investors above average income and growth potential. This industry is extremely volatile as fortunes of success are directly dependent upon the prices of oil (and to a varying extent, natural gas). When the price of oil goes down below the cost of production for many operating wells and fields, as is the current case, companies here lose money. Even those companies that have production costs below the price of oil can lose money due to the corporate overhead, interest expenses and capital expenditures that do not result in productive assets and must be expensed (dry holes). But the flip side is tantalizing to those who possess a long-term view. When oil prices rise enough to make virtually all wells and fields profitable again, the price of stocks in this industry have the potential to soar, providing the selective, patient investor opportunities of massive gains. The key here, as in all successful investing, is to avoid the big losses. Waiting for the right entry point on the right stock is the best advice I can provide, especially when considering investing in this industry. I like to decide first upon a yield that I am willing to accept from each industry, then select from the list above. his way I believe that I have bought a quality company at a bargain that provides a yield that suits my portfolio and adds enough income to allow me to wait patiently for the stock to rebound so I can reap the terrific potential appreciation that lies ahead. This analysis has proven to be difficult in that I cannot, in good conscience, recommend a single company for purchase at current levels. It may also prove to be timely in that many pundits seem to believe that the lows are in place and that great values abound. I disagree! The price of oil may, in fact, experience a rebound once again before plummeting further. Any rebound will undoubtedly be touted as proof that the pundits are right. Memories will be short-lived when oil prices finally make new lows. For those who are concerned that they could miss out on what appears (mirages are always beautiful!) to be a great entry for value investors, I would only add a portion (one quarter or a third) of the full position desired at these levels. If I am right, you can lower your cost basis by adding more when the real bottom is in. If I am wrong, you will not have missed completely the great bottom in oil prices. However, if you really are considering buying shares in this industry now, please take a few moments and read my article linked earlier, if you haven't already, entitled, "Energy Sector Outlook," as it contains a very valuable history lesson on energy prices that all energy investor really need to understand! As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge. More