National Oilwell Varco (NYSE:NOV) has its finger firmly on the pulse of the oil industry. As the sector's leading oil-field equipment manufacturer, it's in constant contact with its customers and knows what they need. One thing many of them have told the company is that they're starving for capital, which is the air the capital-intensive industry needs to breathe. That was the central theme on the company's fourth-quarter conference call, where CEO Clay Williams addressed the impact this issue is having on the sector and what it means for investors.
Conditions in the oil market remain as challenging as ever. While the continued volatility in oil prices is playing a role, it's a secondary issue for the sector. Williams addressed the primary problem by stating:
2019 was a pivotal year for the energy industry. We entered 2019 with commodity and equity markets signaling strongly to market participants that growth for growth's sake without commensurate returns to capital providers would no longer be tolerated. Sources of all forms of capital to the industry -- public equity, private equity, bank debt, public debt -- became scarce and expensive, as evidenced, for example, by the collapse in trading multiples of oil-field public equities in early 2019. At the time, we interpreted this as the evaporation of a widely held narrative, gauzy conventional wisdom that a commodity price spike would someday soon lead us back to a more prosperous oil field and save us all.
That spike hasn't happened, as every rally quickly fades because the industry continues to pump more oil than the global economy needs. That has caused the sector to generate poor investment returns. As a result, Williams noted:
Providers of external capital to oil and gas producers and service companies were exhausted, tired of waiting patiently for recovery that felt like it continued to slip over the horizon. So they choked back on the capital that they were previously pumping into the operations of our customers. Now capital is to oil and gas what oxygen is to the rest of us. Petroleum is arguably the most capital-intensive undertaking of all industrial enterprises, and oil-field services is probably second. Operators react quickly when you choke off their air supply. They pulled back hard on capex budgets ... the industry as a whole, particularly the U.S., finally seemed to be resigning itself to the fact that commodity price spike is not going to save the day and the old way of doing business is not going to cut it.
As Williams points out, with the industry's air supply cut off, it has had to change how it operates, which includes reducing spending. Most oil companies cut capital investment well below their projected cash flow at lower oil prices so that they can reduce debt and return cash to investors. In Williams' view, this capital starvation, while tough right now, is planting the "seeds of a return to prosperity." That's because it's forcing the "industry to reduce its structural overcapacity, taking actions that will return this industry to health." In time, these collective actions will "inevitably lead the industry to better disciplined pricing and shareholder returns."
Rhyming with the past
While Williams painted a rather grim picture of the current state of the oil industry, he ended on an optimistic note:
If I've learned anything from business, it's to be skeptical of conventional wisdom, because collectively, we are all, well, frequently wrong. I would be surprised to see a robust global recovery emerge in the oil field in 2020 or even 2021. So we're managing the business accordingly. However, I do think a recovery will emerge when no one is predicting it. The only facts I know for certain is that the oil industry has seen global growth in demand for almost every single one of its 160 years and that the industry has always been highly cyclical. The current time feels an awful lot like the 1990s when then, as now, capital providers to oil and gas were fatigued and frustrated, another period of capital starvation. And then, as now, the industry responded by trimming overcapacity. History doesn't repeat itself, but it does rhyme, and I'm encouraged that here in the sixth year of the downturn, the oil and gas industry is serious about reducing its structural oversupply.
As Williams points out, the industry's current issues seem to parallel those it experienced in the 1990s. During that period, the sector responded to structural overcapacity issues by trimming the excess. One way it did that was through a series of megamergers that created most of the current leaders. BP started the wave in August 1998 when it agreed to buy Amoco in a $48.2 billion deal. At the time, it was the largest-ever deal in the oil patch. However, Exxon topped it later that year by agreeing to acquire Mobil for $73.7 billion. The wave continued as BP agreed to acquire Arco for $27 billion in 1999, Chevron bought Texaco for $45 billion in 2000, and Conoco merged with Phillips Petroleum in a $35 billion deal in 2001.
While the merger mania of the past hasn't repeated, we've seen some parallels as Shell bought BG Group for $53 billion in 2016 and Occidental Petroleum outbid Chevron to acquire Anadarko for $55 billion last year. Meanwhile, several smaller oil companies have paired up over the past year. More consideration seems inevitable, given the industry's level of overcapacity and the lack of available capital.
Rebuilding the foundation takes time
The energy sector has run out of the oxygen it needs to breathe because investors have grown so tired of its persistent underperformance they've stopped providing capital. That's forcing the sector to finally address its structural overcapacity issues. While it will take time for the industry to rebuild the way it does business, the actions it takes could enable it to, at long last, start creating value for investors.